Budget improves pace of debt consolidation but warns of economic uncertainty

Treasury Secretary Chrystia Freeland will present the federal budget on April 7 in the Ottawa House of Commons.Adrian Wyld/The Canadian Press

The federal government has promised to put the country’s finances on solid footing after a period of explosive spending growth, while warning that the pace of fiscal consolidation could be derailed by growing global economic turmoil.

Thursday’s budget starts better than expected, with the deficit for fiscal 2021-22 standing at $113.8 billion, about $30 billion better than expected in the government’s December update. This is the result of the rapid economic growth that has emerged from the pandemic lockdowns, as well as blistering inflation, which has pushed up prices for consumers but also channeled more taxpayer dollars into the treasury.

Deficits are projected to shrink over the next five years, and the public debt-to-GDP ratio is projected to decline steadily from 46.5 percent in 2021 to 41.5 percent in 2027.

Kelli Bissett-Tom, ratings analyst for Canada at Fitch Ratings, said the federal government’s deleveraging trajectory is trending in a positive direction. At the same time, the government still has a long way to go to consolidate the massive debt accumulated during the pandemic, she said.

“Given the current level of government debt, rapid consolidation is unlikely. But surely this [budget]coupled with more positive than previously budgeted provincial results, … supports a gradual but better than previously expected downward trend,” she said.

In 2020, Fitch downgraded Canada’s credit rating one notch to AA+. Other debt rating agencies, including S&P Global Ratings and Moody’s, have retained their highest rating for Canada.

The government’s debt path comes with caveats. Crucially, the global economy is entering a period of heightened volatility as a result of rapid monetary policy tightening and heightened geopolitical uncertainty, which could derail the fiscal stance.

Central banks have embarked on the most aggressive rate hike cycle in decades to curb high inflation. At the same time, the war in Ukraine has pushed up commodity prices and disrupted supply chains that are still struggling with challenges from the COVID-19 pandemic.

The government’s key economic scenario is based on a survey of private sector economists conducted in February. Given the Russian invasion of Ukraine and the dovish stance of central banks over the past month, these numbers are looking increasingly outdated.

The rapidly changing economic outlook prompted the government to include two alternative scenarios in the budget. If the war in Ukraine drags on and central banks become hyper-aggressive on interest rate hikes, the downside forecast could trigger a major economic shock that could shave almost two percentage points off real GDP growth in 2022 and 2023 and boost unemployment by around 0.7 percent. That would put the debt-to-GDP ratio back on an upward path for several years before it starts falling again.

Rebekah Young, director of finance and provincial economics at the Bank of Nova Scotia, said that downside scenario was unlikely as Canadian household balance sheets were generally in good shape post-pandemic. But she said the government is right to think of downside risks.

“It speaks to the challenge of budgeting at this point because you can think of many possible events that could happen. We now have a global conflict, we still have a pandemic. We have runaway inflation and this political risk, so there are easily five different scenarios that are less than desirable,” Ms Young said.

Debt servicing costs are a key uncertainty factor. As the government’s debt burden skyrocketed during the pandemic — from about $721 billion in 2019-20 to $1.16 trillion in fiscal 2021-22 — debt service fees stayed low, thanks to the bank’s support of Bank Canada held extremely low interest rates.

Now interest rates are expected to rise rapidly, which will increase debt servicing costs as the government rolls over its maturing bonds and issues new debt. The Budget argues that debt servicing costs remain manageable, rising from $26.9 billion in 2022-23 (about 1 percent of GDP) to $42.9 billion (1.4 percent of GDP) in 2026-27 will.

But if interest rates rise faster and higher, it could put pressure on government finances, said Randall Bartlett, senior director of Canadian economics at Desjardins.

“The expectation is not only that short interest rates, but also long interest rates will start to rise in a meaningful way that we haven’t really seen since the Great Financial Crisis,” he said.

“And if that’s the case, the rubber is really going to hit the road on this sovereign debt. … Because every 100 basis point increase in interest rates has the same impact on the deficit as a 1 percent fall in GDP, which is quite significant.”

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