Canada’s 1990s down­grade has lessons for U.S.

Montreal Gazette - - Business - HARRY KOZA

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.

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