Canada’s 1990s downgrade has lessons for U.S.
TORONTO – There’s a lot of angst in global capital markets over the prospect of the U.S. losing its AAA sovereign debt rating, a notion that even a few years ago would have been dismissed as an impossibility.
In Canada, we’re somewhat more sanguine about the prospect, since we’ve been there, done that and got the haircut.
Back on April 28, 1993, the government of Canada had its credit rating cut by the Canadian Bond Rating Service to AA+ from AAA. The Conservative federal government, running the usual huge deficit at the time, was naturally dismissive of the move, saying that CBRS was only a small ratings agency and that the big New York-based raters would likely not follow suit (yet).
CBRS said it cut the rating because of concerns about general economic weakness, rising inflationary pressures, high wage settlements for government unions, high and rising unemployment and a local currency caught in what looked like, at the time, a death spiral.
Ottawa had just issued a new budget and the market had been hoping for some real deficit-fighting measures and was disappointed with a forecast of $30-billion deficits into the distant future.
By 1995, the Liberals had swept back into power, the national debt was peaking at 72 per cent of GDP, and the major international ratings agencies had cut Canada’s sovereign credit rating to AA+ from AAA.
The Wall Street Journal was editorializing about Canada’s parlous fiscal state, making it an “honorary member of the Third World.”
Yet, prime minister Jean Chrétien and finance minister Paul Martin managed to eliminate a $42-billion deficit in only four years, which also helped them win the next three federal elections.
How’d they do it? They cut federal expenditures by 20 per cent, cut 23 per cent of public servants, slashed agricultural subsidies and business subsidies by 40 per cent to 60 per cent, chopped defence spending by 15 per cent, abolished some ministries altogether, and cut transport and science budgets in half.
Of course, they also hiked Canadian Pension Plan and Employment Insurance taxes – er, contributions – and downloaded a ton of federal spending onto the provinces. True, the cause was helped by a rebounding economy (which the U.S. does not quite have at the moment), and as the government cut spending by $14 billion, tax revenues rose by $32 billion, and employment was rising (with the unemployment rate dropping to nine per cent in 1998, from 12 per cent in 1993), which helped by shrinking the welfare rolls and boosting tax revenues.
As far as the bond market went, the repercussions of the downgrade were actually fairly minimal. At the time, the Bank of Canada issued U.S. dollars and other foreign currency-denominated debt to fund its foreign reserve account.
Nowadays, of course, they can issue in Canadian dollars and swap it as needed for reserves. But back then, the downgrade added several basis points to the cost of foreigndenominated issuance. Most of the annual borrowing requirement, however, was done domestically, and domestic investors, pretty much a captive audience at the time, did not demand much of an additional premium for buying government debt that was below AAA.
It was relatively easy for the Bank of Canada to cut back on its foreign financing. This is, of course, a much bigger potential problem for the U.S., which must rely on the kindness of strangers, or at least, China and Japan, to fund its burgeoning debt requirements. International investors will demand higher yields for downgraded U.S. debt. And when you are running a $1.4-trillion deficit, even a few extra basis points adds up to billions of dollars.
Further, the U.S. has far more federal agencies whose borrowing costs will be affected by such a cut than Canada did. Spreads of those agencies will widen if the U.S. is downgraded, and states, whose ratings are based on the implicit U.S. guarantee will see their ratings cut as well, causing further spill-on effects in municipal credits as well.
But it is not all doom and gloom. If there is one thing that the Canadian experience demonstrates, it’s that there is nothing like a ratings downgrade to get politicians to stop their squabbling and get busy doing the necessary.