Ontario’s debt has exploded. Is the province in trouble?

Posted on March 25, 2018 in Debates

TheGlobeandMail.com – Ontario Budget 2018
March 23, 2018 –  and 

After nine years, they’d found their way out.

Last spring, Ontario’s Liberal government unveiled its first balanced budget in nearly a decade, making good on Premier Kathleen Wynne’s commitment to return the province’s books to the black after a nasty recession and a slow recovery. To silence the critics, she also pledged balanced budgets for three straight years.

On Wednesday, that promise gets tossed aside.

Heading into a June election, the Liberals are set to table a budget that includes billions of dollars in new spending – expenses that will require running another deficit. The funding gap will be kept under 1 per cent of the province’s gross domestic product, according to Finance Minister Charles Sousa, but could still run as high as $8-billion.

In Ontario’s Throne Speech this week, the Liberal government argued that the province “has to fight for good jobs and growth.” It is a battle cry for left-leaning voters.

The new spending will add to a debt total that has ballooned since the financial crisis, raising questions once again about whether the Liberals will ever address the burden. The province is coming off a stellar year of economic growth and its jobless rate, at 5.5 per cent, is near a two-decade low. This might be the perfect time to run a surplus and begin repaying debt.

By failing to do so, is the government leaving the province more vulnerable when the next downturn hits? Ontario is Canada’s economic engine, and the way it deals with rising debt could be critical to the country’s future.

How alarming is Ontario’s debt situation?

Unequivocally, Ontario’s debt has grown quickly. The province’s net debt – that is, the amount left after subtracting cash and short-term investments from its debt – is projected to hit $312-billion this fiscal year, or roughly double what it was a decade ago. It could even be a little higher, depending on the accounting method used for pension assets and the cost to lower Ontario hydro bills.

The province’s net debt-to-GDP ratio has edged lower of late, but still sits at 38 per cent, up from 26 per cent right before the Great Recession.

See Chart:  https://beta.theglobeandmail.com/files/graphics/0323-rb-ont-debt-2/0323-rb-ont-debt-2-desktop.png?token=1

Because the debt has exploded, Ontario’s credit rating has been downgraded by three separate rating agencies since 2012. Using Standard & Poor’s scale, Ontario is now rated single-A-plus. The only provinces that fare worse are Prince Edward Island and Newfoundland, whose economies are smaller, less diverse, and also less attractive to foreign capital and workers.

Have Ontario’s Liberals been reckless with the province’s finances?

The debt load isn’t the only way to judge this. In 2011, the government hired former Toronto-Dominion Bank chief economist Don Drummond to make recommendations on getting its books in order. His 544-page report examined nearly every aspect of the budget.

“I would say there probably wasn’t 1 per cent of the people in Canada – including all the writers on your staff – who would’ve put a one-dollar bet on them balancing their budget by the target,” Mr. Drummond said in an interview before the recent budget deficit was proposed. But they did return to the black last year.

“The big surprise is they kept more of a lid on health-care costs,” he explained. The Liberals also took aim at education costs by squeezing teacher wage increases and cutting sick days. Health and education comprise roughly 60 per cent of the province’s expenses.

See Chart:  https://s3.amazonaws.com/chartprod/sEYYKgtofaGdnxrgi/thumbnail.png

Today, Ontario has an operating surplus that amounts to 4.2 per cent of its adjusted operating revenues – or in plain language, it’s running a surplus before accounting for interest expenses on the debt.

Ratings agencies have given the government credit for it. “Measures to control the growth of operating expenditures, wage growth restraint primarily … contribute to Ontario’s strengthening operating results,” Standard & Poor’s wrote in a 2017 report.

How does Ontario’s debt stack up globally?

In March, rating agency Moody’s Investor Service noted that Ontario’s debt level is “among the highest” of all the sub-sovereign jurisdictions it covers. (This refers to governments below the national level, such as provinces and states.) However, while Ontario’s debt looks elevated, compared with many other regions outside of Canada, its credit rating is still very strong.

Take California, for example. It’s become fashionable to note that Ontario has more debt than California, a state of nearly 40 million people with an economy larger than Canada’s. But when judging debt ratings from the three major agencies, the comparison isn’t so cut and dried. On average, Ontario’s ratings are on par with California’s. Moody’s even has Ontario one notch higher, partly because the province has greater control over its taxes and expenditures, such as personal and provincial sales tax rates, royalty rates for resources, as wells as tax rates on tobacco products, liquor and gasoline.

How much has recent economic growth helped Ontario?

The short answer: A lot. In the three years from 2011 to 2013, GDP growth averaged 1.8 per cent. Since then, it has averaged 2.75 per cent annually.

Growth gives a big boost to government revenues and also helps temper the climb in its debt-to-GDP ratio. But with interest rates starting to rise, the fear now is that Ontario’s interest expense will jump. (Interest currently consumes about 8 per cent of provincial government revenues.)

See Chart:  https://s3.amazonaws.com/chartprod/sEYYKgtofaGdnxrgi/thumbnail.png

However, the province planned for this, and has been issuing longer-term debt over the past few years to lock in lower interest costs for longer periods of time.

Still, Moody’s calculated that if federal borrowing costs were to rise by two percentage points by 2021 – a move that would push provincial rates, higher too – Ontario’s interest expense would exceed 10 per cent of its revenues.

How easy is it to fix the debt burden?

Borrowing money is easy; paying it back tends to be much, much harder.

Even if the Liberals are booted from office in June, their successors won’t find it easy to tackle the debt load. As S&P noted in 2017, “we think spending reductions would be very challenging for the province with a growing population, given its education and health-care responsibilities and the share of Ontario’s work force covered by multiyear collective agreements.” An aging population doesn’t help: about 17 per cent of residents are 65 or older.

The Progressive Conservatives may not balk at taking on teachers, given their history of doing so, but health cuts are another matter – especially at a time when many Ontario hospitals are already overstretched.

Infrastructure spending is also a divisive issue. Funding for the likes of sewage and waste disposal, public transit, and social housing has been lacking. The Association of Municipalities of Ontario, which represents cities and towns across the province, is so frustrated that it has asked the province to increase its portion of the harmonized sales tax by 1 per cent, and then hand that money to the individual regions.

If Quebec could fix its books, why can’t Ontario?

Not long ago, Quebec took heat for its finances the same way Ontario does now. The tide started to turn a few years back, when the province began tabling balanced budgets. Then, in 2017, S&P upgraded Quebec’s rating to double-A-minus from single-A-plus, putting it higher than Ontario’s. It was a landmark moment.

Quebec certainly took its finances seriously, raising its provincial sales tax to offset a federal GST cut and holding the line on health spending. But it also benefits from federal largesse – it receives transfers from Ottawa over and above Ontario’s.

What Quebec definitely did right was show its seriousness about debt by outlining a credible path to repayment. In 2006 the province passed a law that established a Generations Fund, whose revenues come from sources such as Hydro-Quebec water-power royalties, mining revenues and a specific tax on alcoholic beverages. Those revenues have reached more than $2-billion annually, and can be used solely to pay down the debt. This month, Quebec’s Liberal government announced it will use $10-billion over the next five years for this purpose.

See Chart:  https://beta.theglobeandmail.com/files/graphics/0323-rb-ont-debt/0323-rb-ont-debt-desktop.png?token=1

For all the progress Quebec has made, it still has a higher debt ratio than Ontario, at 46.3 per cent of GDP. But it’s heading in the right direction.

See Chart:  https://s3.amazonaws.com/chartprod/xjW86j4LjNy9Kg2XR/thumbnail.png

How much do debt investors worry about Ontario?

Not much. Ontario debt still sees “very robust demand,” said Richard Sibthorpe, who runs debt capital markets at Bank of Montreal. “There’s been consistent and very strong demand for government debt in general,” he said. On top of that, “Ontario’s one of the most sophisticated borrowers in the world.”

In that case, should voters worry?

Some fear the Liberals have lost the plot. They worked hard to get the province’s books in order, and now they’re spending again, for what looks like political purposes. Already one rating agency has gone public with a warning. “A return to deficit borrowing during a period of economic growth would be inconsistent with [our] current rating expectations,” Fitch Ratings wrote in early March, suggesting another downgrade is possible.

The bigger problem is that the debt burden has given the province less flexibility to spend, as governments must, when the next recession comes around – just as sizable federal deficits in the 1980s made it harder for Ottawa to respond to the recession of the early 1990s.

“I don’t really care about debt reduction itself,” said Mr. Drummond, who gave the Liberals their fiscal road map. “It’s the level of the debt burden … [38 per cent of GDP] is just too high. It makes them so exposed if they get into a downturn.”


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