Provinces face challenging fiscal risks

Thanks to COVID- 19 and our response to it, public debt is on the rise again. And stimulus spending over the coming years will increase it further. Concern about sustainable public finances, fiscal anchors, interest burdens and so on, is therefore naturally growing.

A key concern — apart from record- high government deficits — is whether interest rates will rise or economic growth rates will fall. If governments can borrow at interest rates that are less than the rate of economic growth, then the ratio of debt to GDP can fall even if they run ( modest) deficits forever. If the interest rate is one per cent, say, and the economic growth rate is two per cent, then the numerator of the debt-to- GDP ratio grows at one per cent ( as governments borrow to pay interest) while the denominator grows at two per cent, which means the ratio of the two actually falls. But if interest rates exceed growth rates, then the numerator grows more quickly than the denominator and debt ratios rise — maybe quickly — thus forcing governments to raise taxes, cut spending or both to keep their finances sustainable. So how interest rates and growth rates compare is crucial.

The recent Fall Economic Statement emphasized that interest rates typically are lower than economic growth rates. The historical record confirms this not only for Canada but for most developed countries over most of the past two centuries. Many economists expect this pattern to hold well into the future. It turns out the 1980s and 1990s, when interest rates generally exceeded growth rates, were an anomaly.

But

historical averages aren’t all that matter. We and our governments mustn’t lose sight of the variability of interest rates and growth rates over time. The fiscal risk this variability causes is especially important for provinces.

Provincial government debts are at roughly 40 per cent of GDP — nearly as large as the federal government’s debt ratio, though they receive far less attention. And provinces pay higher interest rates and are more vulnerable to credit shocks. They also rely on narrower and thus more volatile revenue sources and will bear the brunt of rising health-care costs.

In a recent analysis for Finances of the Nation, we went beyond these theoretical concerns and examined the relationship between annual growth rates and interest rates on 10-year bonds for each of the provincial governments from 2006 to 2018. We also examined the volatility of growth- interest differentials to explore the range of possible future debt levels in Canada. The results were revealing.

First, the good news: the federal government enjoyed strong fiscal fundamentals, with economic growth exceeding interest rates on 10-year government bonds by an average of 0.9 percentage points. And although provinces do tend to have worse growth- interest rate differentials than Ottawa, most still have higher growth rates, on average, than borrowing rates.

But not all the news is good for the provinces. Ontario and Quebec, which accounted for roughly twothirds of the provincial bond market in 2019, had borrowing rates essentially equal to their growth rates. And Nova Scotia and New Brunswick faced interest rates significantly higher than their growth rates.

Worse, and

of

greatest concern for future debt sustainability in Canada, is the fact the fiscal risks facing the provinces are large. The growth rate-interest rate differential rises and falls from one year to the next much more for provinces than it does for the federal government. Not surprisingly, this volatility is particularly pronounced among the three oil- producing provinces of Alberta, Saskatchewan, and Newfoundland and Labrador.

This greater variability matters a lot for our future public debt levels. The wider swings of the growth rate-interest rate differential mean future debt will span an increasingly wide range. Even if provincial governments enact fiscal reforms to fully fund program spending — like health care — without borrowing, their debt levels have a greater than 50 per cent chance of rising above their current levels. We also find a roughly one- in- four chance that the overall provincial debt to GDP rises by nearly 10 percentage points in the coming decades. That is roughly half the federal increase due to COVID-19 and has a non- trivial chance of occurring even if provinces pay for all their non-interest spending with taxes.

The picture for Newfoundland and Labrador is particularly grim. Even without any borrowing to fund program spending, it has a one-in-three chance of seeing its debt- to- GDP ratio rise 10 points within the next decade. British Columbia, by comparison, has a near-zero risk of this happening. Why? Because of its lower debt to begin with and its more stable borrowing and growth rates. This reveals that higher debt is not only a burden that has to be serviced but also exposes provinces to increasingly challenging fiscal risks.

None of this means large fiscal adjustments are required yesterday — or even today. Provinces have time to adopt a more gradual path to fiscal consolidation than they took in the 1990s. And whatever the best path to fiscal consolidation may be, it clearly differs across levels of governments.

So far only slight attention has been paid to fiscal risks and their importance for provincial governments. They need to be front- andcentre in discussions about Canada’s fiscal sustainability.

provinces pay higher interest rates and are more vulnerable to credit shocks.