Special Report

November 03, 2022 | 18:05

Fall Economic Statement — Modern Fiscal Reality

Economist

Chief Economist and Managing Director
Economics

Douglas Porter has over 30 years of experience analyzing global economies and financial markets. As Chief Econom... (Read more)

Robert Kavcic

Senior Economist and Director
Economics

Robert has been with the Bank of Montreal since 2006. He plays a key role in analyzing regional economic, fiscal... (Read more)

Benjamin Reitzes

Managing Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

Douglas Porter , CFA

Chief Economist and Managing Director
Economics

Douglas Porter has over 30 years of experience analyzing global economies and financial markets. As Chief Econom... (Read more)

Robert Kavcic

Senior Economist and Director
Economics

Robert has been with the Bank of Montreal since 2006. He plays a key role in analyzing regional economic, fiscal... (Read more)

Benjamin Reitzes

Managing Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

First the good news. Ottawa’s budget deficit continues to track considerably lower than expected versus this past April’s Budget, with the gap slated to drop to $36.4 billion (initially pegged at $52.8 billion) in the current fiscal year, after landing at $90.2 billion in FY21/22 (vs. $113.8 bln). The positive surprise has been led by a wave of revenues, powered by lofty commodity prices and this year’s economic re-opening. Even higher inflation has played a temporary supporting role, as revenues swell in line with rising prices and incomes, while some expenses only respond with a delay. And, importantly, Ottawa is prudently booking some of the short-term windfall by letting it flow to a lower deficit, and not turning around and boosting spending significantly further. Today’s Fall Economic Statement contains only a few moderate measures to support households, struggling with the highest inflation in 40 years.

Now the less-good news. Less than half of this year’s revenue windfall will make it through to an improved bottom line. Moreover, the double-whammy of slower (or no) growth and rising interest rates will limit flexibility into 2023. As noted above, the boost to government finances from higher inflation is temporary. Eventually, costs do catch up to the run-up in prices, and revenues get crimped by the economic slowdown. Accordingly, after a nice run of better-than-expected fiscal outcomes, Ottawa’s finances are expected to turn more challenging next year. Finance expects the budget deficit to narrow slightly again in the coming fiscal year (starting on April 1, 2023) to $30.6 billion, or just 1.1% of GDP, and then to $25.4 billion in the following year. However, we suspect that the economic and interest rate scenario these projections are built upon are a tad optimistic, and lean closer to Finance’s so-called downside scenario.

A rising interest burden is an added thorn in the fiscal outlook. After a lengthy period where interest payments fell, and fell heavily, both as a share of GDP, but even in dollar terms, they are now vaulting higher amid the sharp back-up in rates. Because Ottawa’s debt maturities are reasonably long—the aim is to lift the average term to maturity to 7 years by the end of this fiscal year—it takes time for the rate rises to fully show up, but they are already beginning to weigh. For example, Ottawa now expects debt-service costs to rise from $24.5 billion in the prior fiscal year to $34.7 billion this year and then $43.3 billion in the coming fiscal year. As a share of GDP, that will weigh in at 1.5% versus 1.0% in FY21/22 (and the record 6.5% in 1990). Perhaps more telling, they will thus rise to 9.4% of revenues from 5.9%. However, that’s still a long way from the bad old days of the early to mid-1990s when they peaked above 33% of revenues.

Even with the sharp back-up in interest costs and an expected slowdown in revenue growth, the bigger picture is that government finances have recuperated much faster than many could have dreamed of a year ago, let alone during the depths of the pandemic in 2020 (when the deficit surged above $327 billion). Ottawa’s debt-to-GDP ratio is now expected to recede to 42.3% from 45.5% last year and the pandemic peak of 47.5%. While that’s still a big step up from 31% in the pre-COVID years, it compares favourably versus many other major economies. That’s true even when the provinces are included, where fiscal repair has unfolded even more rapidly (see Appendix). The main point is that while the fiscal outlook will prove to be more challenging again in coming years, this year’s revenue windfall and the relatively prudent decision by Ottawa to bank a sizeable share of it suggests that the storm can be weathered.

Summary of Major New Measures

Combined with some measures announced since Budget 2022, there is $13.4 billion worth of new spending rolling out, with $6.1 billion of that total featured in this update. Some will ask, isn't this counterproductive? Here's a balanced view: Yes, Ottawa is technically adding stimulus at a time when the Bank of Canada is fighting hard against inflation. But, total net new measures this year weigh in at 0.5% of GDP, which shouldn't move the needle too much.

Here are some of the notable items announced in this update:

Tax on share buybacks: Ottawa will introduce a 2% tax on the net value of share buybacks. Details will be provided in the Budget, with an implementation date of January 1, 2024.

Clean tech investment tax credit: A refundable tax credit of 30% on the capital cost of equipment ranging from solar, wind and water energy generation, to items like air-source heat pumps. This is expected to cost just over $1 billion per year over the coming three years.

Home flipping tax: Ottawa is going ahead with its plan to make the profit on homes sold within 12 months of purchase fully taxable. This update expands the tax to also cover assignment sales that are sold within a 12-month window.

Credit card fees: The federal government will work with payment processors and financial institutions to lower fees for small businesses. Government will step in with legislation if something is done on this front by early next year.

Interest on student loans: Canada Student Loans and Canada Apprentice Loans will become permanently interest-free as of April 1, 2023. This will cost roughly $550 million per year going forward.

Economic Outlook

Ottawa is basing this fiscal update on 3.2% real GDP growth this year, followed by just 0.7% growth in 2023 and a moderate 1.9% by 2024. The assumption for next year, which is based on the consensus of private sector forecasters roughly a month ago, is above our call of flat or 0.0% for real GDP, though we look for a mild recovery in 2024. Of course, nominal GDP has been the big factor helping to drive the upside in revenues, and this year's double-digit surge is expected to fade fast as both real and price growth simmer down meaningfully in the year ahead. And we are generally in-line with the consensus on this measure for next year.

We would also highlight the interest rate assumptions underlying the projections. Normally, this forecast does not provide much drama, but these are patently not normal times. The consensus looks for 3-month T-bills to average 3.6% next year, and pegs 10-year GoC bond yields at 3.1%. Both look at risk of seriously undershooting reality, as bills are currently nearly 4% (with further BoC rate hikes incoming) and 10s are above 3.4%. This is where our call lines up better with Ottawa's downside scenario; that version looks for a moderate back-up in the deficit to above $50 billion next year.

Medium-Term Fiscal Outlook

The base case medium-term fiscal outlook is also somewhat improved relative to the budget plan. While next year's deficit is still well below the initial mark, FY24/25 and beyond now run closer to Budget 2022 projections, albeit slightly improved. Looking well down the line, Ottawa has bravely pencilled in a small budget surplus for FY27/28. Hope springs eternal.

While discussion of fiscal anchors has been downplayed, the debt-to-GDP ratio eases further this year at 42.3%, and is projected to still gradually fall to 37.3% by the end of the forecast horizon in FY27/28. While the economic scenario underlying the call appears on the optimistic side, it's encouraging to see the debt ratio at least headed in the direction of pre-COVID levels after the big jump in 2020. Even Ottawa's downside scenario looks for the debt ratio to drop to just over 40% at the end of the forecast horizon, a moderate improvement.

Debt Management Strategy Update

The Debt Management Strategy Update reflects the changes that have taken place in the Government of Canada bond auctions. Total financial requirements are projected to fall $39 billion, which cuts bond issuance by $21 billion (to $192 billion) and the Treasury bills stock by $21 billion from levels forecast in the Budget. Lower borrowing needs are in line with the cuts to auction sizes already put in place, with the drop coming across the curve (2-years through 30-years) cutting benchmark sizes for 2-, 3- and 5-year maturities. Green bonds issuance is unchanged. In a surprise move, the government has decided to stop issuing Real Return Bonds (RRBs) effective immediately due to "low demand". The government also announced its intention to issue $500 million of an Ukraine Sovereignty Bond, with the intention to make the bonds available to the public.

Bottom Line

Ottawa’s fiscal update presents a healthier picture, thanks entirely to the tremendous strength in revenues flowing from robust income growth. Combined with strong nominal GDP growth, the debt-to-GDP ratio is now seen coming down further in the current fiscal year to 42.3% and gradually fading from there—even in the downside economic scenario. Assuming the government adheres to its election platform, next year's budget will provide a more complete measure of the medium-term fiscal landscape. At that point we will also have a much better bead on how high interest rates will need to go to finally crack inflation. For now, today's fiscal news can be characterized as moderately positive, as Ottawa largely steered clear of aggravating an already tough inflation backdrop.

Appendix: What About the Provinces?

The fiscal situation at the provincial level has evolved much like that in Ottawa. That is, strong and steady upside surprises over the course of the past year, led by revenues. Indeed, provincial public accounts for FY21/22 and fiscal updates for FY22/23 are rolling in, and they've been strong almost across the board. But, there is downside risk to the economic outlook in 2023 relative to fiscal plans.

The combined provincial budget balance registered a $9.2 billion surplus in FY21/22, compared to a massive $76 billion deficit originally expected during the 2021 budget season. With a few public accounts still pending, six of ten provinces were in the black. Stronger-than-expected revenues were the biggest driver, helped by faster economic recoveries and high inflation.

That strength is also carrying into the current fiscal year, with the combined FY22/23 deficit now estimated at a small $3.2 billion (pending an update from Ontario, which could easily swing the collective balance into surplus). With the exception of Nova Scotia (very minor downward adjustment), every province to report has done so with an improved budget balance. An official post-election update from Quebec is also pending, but the CAQ platform pointed to a return to deficits.

Looking ahead, downside risks to the growth forecast through 2023 are going to permeate through provincial budget forecasts, with all provinces likely to revise down their 2023 real GDP growth assumptions, if our current outlook is any guide. The downside ranges from a few ticks in parts of Atlantic Canada, to as much as 3.5 ppts in Ontario. Higher inflation will act as a cushion through nominal GDP, but the combination of higher interest rates and wider provincial spreads will also add to expenses. The main takeaway is that most provinces, while now seeing upside to their FY22/23 results, could see that momentum fizzle as 2023 growth forecasts begin to get revised down.

Total provincial borrowing this fiscal year is estimated at $88 billion. That will be down from the pandemic peak of around $150 bln, and from last year ($96 billion). Still, the provinces are somewhat more active than pre-COVID, when the run rate was around $80 bln. To date, just over half of the combined FY22/23 borrowing program has been completed.