Alison Redford made a show last year of demanding an apology from Ontario’s Dalton McGuinty for suggesting his province’s economic struggles and exploding deficit were the result of a petrodollar benefitting Western Canada. McGuinty retracted the comment, but eight months later announced his resignation amid a fractious minority parliament, a provincial credit downgrade and a war with teachers over freezing salaries to plug a potential $16-billion budget hole.
McGuinty may have been pilloried in the West for blaming Ontario’s woes on high oil prices, but in a televised address last month the Alberta premier was also pointing fingers, blaming her province’s projected $6-billion deficit on a “bitumen bubble” that was depressing Canadian oil relative to world oil prices.
Her answer to the problem wasn’t that the province should raise taxes or cut infrastructure spending, but that it would convene a summit of experts and “everyday Albertans” to come up with solutions to Alberta’s ballooning deficit. That was hardly reassuring to her critics. “If Alberta cannot balance its budget with a 4.5 per cent unemployment rate and $85 per barrel of oil, no province can,” fumed Wildrose MLA Rob Anderson.
Redford and McGuinty come from a long provincial tradition of blaming external factors for their chronic budget deficits, while continuing to overspend. It’s a habit that exposes one of the most overlooked crises in Canadian finances: Even as Canada is held up as a model of fiscal responsibility around the world for our relatively low federal debt, our provinces are swimming in red ink.
With $660 billion in federal debt, Canada’s national debt-to-GDP ratio looks reasonable at 36 per cent, compared to, say, America’s 72 per cent. But add in the estimated $589 billion in provincial debt and we’re suddenly at around 86 per cent, putting us close to the 90 per cent debt burden analysts say begins to harm economic growth. Factor in other debts, such as pension liabilities and the debts of Crown corporations, and Canada’s debt suddenly rises to 104 per cent of GDP, according to the International Monetary Fund. (By comparison, Italy stands at 126 per cent.)
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“One reason we have a strong currency is because we have our fiscal situation under control,” says Philip Cross of the Macdonald-Laurier Institute, an Ottawa think tank. “But people are talking about the federal government. If people added in the provincial governments it’s not as bright a story.”
That’s something of an understatement. Provincial governments are hurtling toward financial disaster at breakneck speed. It’s the provinces that shoulder most of the burden of an aging population, with rising health care costs and massive demands for infrastructure spending. Couple that with public sector compensation demands and a political refusal to make tough spending decisions, and provincial budgets could quickly spiral into a crisis that engulfs Ottawa and risks the country’s reputation as a fiscal stalwart—and, ultimately, destabilizes the economy.
Provinces have suffered a slew of grim financial news recently. In December, ratings agency Moody’s put B.C. on notice for a downgrade of its $40-billion debt because of rising deficits and lower royalties for coal and natural gas. Ontario saw its bonds downgraded last spring after its debt skyrocketed 70 per cent since 2008. Half the provinces, including Ontario and Quebec, have debt-to-GDP ratio as big or bigger than the federal ratio of 33 per cent.
Last fall, the Macdonald-Laurier Institute found that Ontario’s debt was worse than that of California—a state with such troubled finances that it once was forced to issue IOUs instead of income tax refunds. The Fraser Institute is even less kind to Canada’s largest province, pointing out in a new study that the relative size of its debt load is exactly where Greece was in the 1980s, and warning that the basket case of Europe could be “ a cautionary tale” to all Canadian provinces.
Ontario is hardly alone. Across the board, provincial governments have spent in excess of their budget forecasts, with resource-dependent western provinces the worst offenders. CIBC World Markets chief economist Avery Shenfeld noted last week that nine of the 10 provinces expect to miss their budget targets this year thanks to slower economic growth.
It’s a long-standing problem. Combined, federal and provincial government spending has exceeded budget targets by $82 billion over the past decade, according to a report from C.D. Howe Institute, with the provinces accounting for the majority of the overrun. It called the provincial tendency to blow budgets a problem that was “too common to be accidental.”
While Bank of Canada Governor Mark Carney has chided Canadian households for racking up the debt, Douglas Porter, the chief economist at BMO Capital Markets, argues households have been relatively prudent spenders compared to provincial governments. “Policymakers have been pretty quick to point to the buildup of household debt and to some extent they’ve done a good job of shifting the focus away from government debt,” he says. “But some of the provinces are in as difficult shape as they’ve ever been and they should be back on the radar.”
Part of the problem is a tendency, almost compulsion, for provinces to issue overly sunny revenue projections. In Alberta, Redford ran on an election campaign last year that assumed oil prices of $100 per barrel, even though prices realized by Alberta producers are tracking closer to half that. (Not only have petroleum prices fallen, but a discount is applied to oil sands crude because of the difficulty in getting it to American refineries.)
In November, Saskatchewan slashed its forecasted surplus from $95 million to $12.5 million because of lower revenue from potash mining royalties. Still, the province only dropped its predicted price for the fertilizer from $477 per ton to $440—even as a Reuters poll of North American analysts foresaw prices falling to $417 this year.
All the positive talk from Ottawa and elsewhere about Canada’s strong finances and resource-based economy will only make it more difficult to convince Canadians they need to accept the tough sacrifices needed to repair provincial balance sheets.
For instance, Ontario refused to implement most of the key recommendations from Don Drummond, the former TD Bank chief economist hired to find solutions to the province’s deficit crisis. Drummond offered 362 different ways Ontario could fix its finances, including scrapping all-day kindergarten, capping health care funding and closing casinos. Critics have called on B.C. to raise income taxes and corporate taxes, which the province likes to boast are among the lowest in the G7.
Likewise, in Alberta a growing chorus has urged the government to boost corporate taxes and royalty fees and scrap its flat-rate 10 per cent personal income tax for a progressive tax system. Jack Mintz, the influential University of Calgary tax expert, has called on the province to implement a sales tax to mend its finances. Most importantly, all provinces must get tough when it comes to reforming public sector wages and benefits, says Dana Peterson, an economist at Citi Global Economics. She’s mapped out the wages and hours worked in every sector of the Canadian economy and found teachers and public sector employees clock the fewest hours and have the priciest hourly wages. “It’s not that the problem can’t be dealt with. But it’s going to mean sacrifice,” Peterson says. “It’s going to mean that people are going to have to really start to contribute to their retirement and potentially to their medicare costs.”
Tax hikes, spending cuts, union concessions—all of that is easier said than done. Ontario teachers staged one-day strikes to protest the government’s plan to scrap wage hikes in the their contract. Last year Quebec faced violent months-long protests from students when it tried to increase university tuition by a modest $325 a year over five years. Boiling down the issue for Albertans, Redford recently warned residents that for new hospitals, highways and hockey arenas to be built, the province will have to dip into the red. “If everything we do right now is funded fully with cash in the bank,” she told reporters, “then we are never going to build anything more in this province.”
Line up Canada’s provinces side by side with American states and we start to look like the poor cousins. The ratio of state debts to GDP range from close to 2 per cent in Tennessee to 20 per cent in Massachusetts. California’s debt amounts to just 7.7 per cent of GDP. In contrast, no province east of Manitoba has a debt ratio lower than 25 per cent, with debt equal to just shy of 50 per cent of Quebec’s economic output and some 38 per cent in Ontario. “There’s no state on the level of Ontario and Quebec,” says Marc Joffe, a consultant and former senior director at Moody’s Analytics. “Not even close.”
In the report he authored for the Macdonald-Laurier Institute last fall, Joffe calculated that nearly every Canadian province faces a 50-per-cent chance of defaulting on its debts within 30 years. Ontario, with its huge and persistent deficits, is the most likely to default within the next 10 to 20 years. But the real surprise is Alberta, which Joffe estimates has an 84 per cent chance of defaulting, assuming interest rates rise to historic norms and the province maintains its current unsustainable deficit trajectories.
It’s an unexpected prospect given that Alberta doesn’t actually have any debt right now. But Joffe says it reveals just how dependent the province is on volatile oil revenues. Alberta also has a rapidly aging population and a deficit that has been rising despite commodity prices that remain above their long-term averages.
A default has happened before. Alberta is the only province in Canadian history to renege on its debts. The province suffered a major financial crisis during the Great Depression and eventually defaulted on $62 million in bonds before it was bailed out by the federal government. Much has changed since then, of course, with the discovery of oil. But it raises an important question: How likely would the federal government be to come to the rescue of provinces if they find their debts unsustainable? Very likely, if history and the expectations of debt investors are any indication.
Nearly half of Canadian provinces had to be bailed out in the 1930s. Ottawa has since introduced transfer and equalization payments to the provinces, but that hasn’t kept their finances stable, nor does it mean the federal government won’t feel obliged to bail them out.
Joffe believes the Canadian government set a lasting precedent with its past provincial bailout, instead of letting them learn from their excesses. “Maybe that would’ve been a teaching movement and we would have had long-term fiscal restraint,” he says. “But we didn’t get that. Instead, we got a high-risk situation.”
Even as recently as 1993, Saskatchewan openly mused about defaulting after its credit rating was slashed to near junk-bond status. In a series of internal memos that were eventually made public, the federal government of the time quietly worried that it would have to come to the rescue of both Saskatchewan and Newfoundland, whose credit ratings were then on par with Colombia and El Salvador.
Even today, ratings agencies give provincial governments better credit ratings than U.S. states, despite the fact that provinces face larger per capita debts and interest payments. Joffe says credit rating agencies have factored in an 88 per cent probability that when provinces finally hit the wall, Ottawa will come to the rescue.
Despite this, federal transfer payments to the provinces, which were roughly $62 billion last year, come with virtually no strings attached and aren’t contingent on how well those governments manage their finances. Prime Minister Stephen Harper has signalled that his government is unlikely to change that when the current federal-provincial agreement expires in 2014, telling reporters last year that he didn’t “anticipate major changes to the program.”
But if the federal government is indeed expected to bail out deadbeat provinces, that needs to change, argues Glen Hodgson of the Conference Board of Canada. “There should be a heavy political price to pay” he wrote in a blog post, with the feds making money contingent on deep cuts to provincial spending and federal approval of future provincial budgets. Such a scenario is not all that different from Germany demanding Greece balance its books in return for rescue funds.
A provincial default will likely never happen. But Canadians would be wise to keep the past in mind before they start thumping their chests about Canada’s strong federal finances, since today’s provincial budget problems could easily become tomorrow’s national debt crisis.
It’s difficult to lay the blame entirely on provincial governments for their budget problems. Provinces face fluctuating and uncertain revenues compared to the steady stream of income tax and GST that flows to the federal government. For instance, a $1 drop in oil prices translates into a $223 million plunge in provincial revenues for Alberta. Similarly, natural gas royalties were Alberta’s largest source of resource revenues for most of the last decade. But with stubbornly low prices, gas revenues have fallen from $8 billion a year in 2006 to little more than $1 billion.
Unlike American states, provinces are also responsible for health care—the single largest cost to governments—and have faced expenses that have risen much faster than the federal transfer payments used to pay for them. In Ontario, half of provincial spending goes just to pay for health care, a figure that could hit 80 per cent within a few years.
What’s more, as Ottawa makes changes to balance its books, the burden of rising health care costs will increasingly fall to the provinces, according to a report last year from Parliamentary Budget Officer Kevin Page. With the feds planning to link increases in health transfers to economic growth beyond 2017, Page’s office predicts that health care costs will quickly begin to outstrip the federal funds used to help pay for them. But with a rapidly aging population, curbing rising health care costs is no easy task. Provinces will continue to face a host of demands on their budgets. Highways must be repaired. Hospitals need to be built. And a greying workforce means provinces will have less tax revenue to pay for it. Solving the problem will take more than issuing bonds or cutting teacher’s salaries for a few years. These measures just kick the can down the road, which is precisely what countries like the U.S. and Greece did—until their debts reached crisis proportions.
“The old band-aid of ‘let’s freeze spending for a couple of years’ isn’t going to solve this problem,” says Cross. “We are going to have to start taking this seriously or there are going to be some Greek-like consequences.”
What, us worry?
While their ledgers drip with red ink, provincial leaders are holding to the age-old tradition of continuing to overspend while blaming external factors for their chronic budget deficits
Consistently blows its budget: total spending overruns from 2000 to 2010 were $6.1 billion or 15% of its 2011 budget Deficit expected for fiscal 2012-13: $1.47 billion Debt downgraded from stable to negative by Moody’s in December
Chance of default within 30 years: 53.6%
Consistently blows its budget: total spending overruns from 2000 to 2010 were $10.4 billion or 25% of its 2011 budget Faces $6 billion budget shortfall
Chance of defaulting on debt within 30 years: 84%
Consistently blows its budget: total spending overruns from 2000 to 2010 were $3 billion or 30% of its 2011 budget
Chance of default within 30 years: 47.8%*
Deficit for fiscal 2012-13: $11.9 billion Provincial debt rating downgraded last year Net debt per capita: $18,889 Debt-to-GDP ratio: 37.7% Net debt: $255 billion
Chance of default within 30 years: 79.3%
Deficit for fiscal 2012-13: $567 million Net debt per capita: $12,734 Debt-to-GDP ratio: 27.1%
Chance of default: 66.7%
Consistently blows its budget: total spending overruns from 2000 to 2010 were $10.4 billion or more than 15% of its 2011 budge Net debt per capita: $22,001
Debt-to-GDP ratio: 49.6%, highest in the country
Deficit for fiscal 2012-13: $411 million Net debt per capita: $14,553 Debt-to-GDP ratio: 33.1%
Chance of default within 30 years: 52.9%
PRINCE EDWARD ISLAND
Consistently blows its budget: total spending overruns from 2000 to 2010 were $300 million or 20% of its 2011 budget. Debt-to-GDP ratio: 34.6% Net debt: $1.8 billion
Chance of default within 30 years: 57.1%
Deficit for fiscal 2012-13: $277 million Net debt per capita: $14,463 Debt-to-GDP ratio: 34.8%
Chance of default within 30 years: 53.6%
Deficit for fiscal 2012-13: $726 million Net debt per capita: $17,360 Debt-to-GDP ratio: 26.4%
Chance of default within 30 years: 50.2%