Questions the Fiscal Update Won’t Answer
Ottawa’s fiscal “snapshot” on July 8 will be the first official update of federal government finances since the pre-pandemic days of late last year. Instead of a near-2% growth rate for 2020, we are now looking at a decline of at least 6% (latest consensus is -6.6%). Along with the steep pullback in oil and other commodity prices, that 8 percentage point swing in the GDP outlook has carved a canyon in government revenues. With massive spending on much-needed income support measures added on, the budget deficit will likely swell to over $250 billion (or more than 11% of GDP) in this fiscal year, versus pre-virus estimates of just under $30 billion (close to 1% of GDP). This will bump up the debt/GDP ratio from just over 30% to roughly 44% in one fell swoop (Chart 1). And that’s before any additional measures that may be announced in coming months to help support and reinforce the recovery. These points are likely to be the main thrust of what the fiscal update will address, but here are some key questions that won’t be addressed:
1) How are we going to ultimately pay for this?
Fitch’s downgrade of Canada’s credit rating on June 24 was a stark reminder that there are indeed limits to how far the fiscal taps can be opened during this extreme economic event. But while we have little quarrel with Fitch’s logic, there are a few points to make in considering how quickly the fiscal support measures need to be reversed in coming years. First, because of record low bond yields, and negative in real terms, the interest cost of the rising debt burden is very modest; we’re in a different world than the bad old days of the 1980s/90s (Chart 2). Second, the vast majority of the temporary rise in Ottawa’s new debt is being absorbed by the Bank of Canada. And, while the BoC’s holdings of federal government debt as a share of the total has risen abruptly from less than 14% at the start of the year to around 27% now (Chart 3), that’s still below the share of domestic government debt held by central banks in Japan, Germany and Sweden, for example. Third, Canada’s overall public sector net debt remains moderate among major economies, and especially when compared to the U.S., Britain, or the Euro Area (Chart 4).
The main point is that, while deficits of over 10% of GDP are simply not sustainable for long, Ottawa should aim to bring down the deficit only insofar as it doesn’t threaten the fledgling recovery. A gradual glide-path back toward smaller deficits is entirely appropriate, and manageable from a long-term fiscal sustainability lens, particularly as long as bond yields remain firmly planted below inflation. At anything close to current long-term interest rates, deficits of 2%-to-3% of GDP are sustainable, and would stabilize debt ratios at around 50% of GDP.
2) Who will pay for this? Higher taxes or spending cuts?
Our core view is that the emphasis should be entirely on ensuring that the recovery first takes hold before any consideration is given to restraint measures. Some of the one-time fiscal costs will naturally roll off as the economy begins to recover (and, to be clear, this is not spending restraint or cuts, just an end to emergency measures). Along with some underlying recovery in economic activity and revenues, this will go a long way to reducing the deficit to more manageable levels by next year, closer to $100 billion, or around 4% of GDP. That’s still considerably larger than pre-virus trends of about 1% of GDP, and would lead to some upward drift in debt ratios.
Given that the unemployment rate is likely to still be well above pre-virus levels when the economy ultimately emerges on the other side of the pandemic, any serious spending restraint will be a very tough sell. Program spending had only just returned to its long-run trend in the prior fiscal year (Chart 5). However, we would assert that the economic argument for any tax increases is also very thin—Canada already has one of the highest top marginal tax rates in the world, and is no longer notably competitive on corporate rates, while higher sales taxes are nearly a non-starter. But that’s the economic argument; the political argument is an entirely different matter in current circumstances.
The bottom line to these two questions is that we are unlikely to reverse the one-time damage to debt/GDP—so it’s a one-time deterioration in government debt tallies that will mostly “pay” for this. Still, ultimately, some moderate fiscal tightening will eventually be required to stabilize debt ratios.
3) What will happen when programs expire?
A big concern for the recovery is what happens when massive federal support programs start to expire. The CERB, for example, has served more than 8 million unique applicants with $2,000/month. Ottawa was already faced with a concerning situation whereby many CERB recipients were set to begin falling out of the program in early July as their 16-week payment period came to an end. Presumably, some could shift into the EI program, but eligibility would vary and lead to dropped coverage. Not wanting to subject the economy to a negative shock just as it is re-opening, Ottawa extended the program by another 8 weeks, which will take initial recipients into early-September. The CEWS was also already extended once (by 12 weeks), and the commercial rent relief program was extended by a month, to cover July. Suffice it to say that some sectors won’t be nearly back to pre-COVID capacity even when these extensions run their course, so many Canadians will slip into a tougher financial situation. That said, these three benefit programs alone are now expected to cost almost $130 billion in FY20/21, with the tab growing each time a program is extended. Therefore, Ottawa will have a tradeoff to make between maintaining support and digging deeper into deficit—so far, it’s been the latter.
A separate aspect is mortgage deferrals, where Ottawa is not bearing a direct fiscal cost; but, more than 15% of mortgages have seen some deferral, according to CMHC. This six-month deferral period will also begin to wind down for early applications in the fall and, while there won’t be an outsized payment waiting at the other end, interest continues to accumulate on the outstanding balances, increasing debt-to-income ratios.
4) What will the next phase of fiscal policy look like?
Fiscal policy so far during the pandemic can be characterized as a group of measures to help maintain solvency—keeping households able to pay their bills, and small businesses in place to reopen when eventually allowed. As the pandemic fades, presumably policy will shift more toward incenting growth, job market participation and business creation (or re-creation) in order to help push the economy back to capacity. Some provinces, for example, have already pulled forward capital spending dollars and even cut tax rates. While the next phase is probably not something that will be covered in the upcoming fiscal update (2021 budget, perhaps), it will likely take on a more traditional stimulus feel, with the biggest new wrinkle being measures to pull people back into the labour market after (in some cases) 6 months of generous government support. We don’t believe tax increases should, or will, be a part of fiscal policy through the next phase. But, the longer-term challenge of rebuilding fiscal capacity will inevitably be waiting at the end of the recovery period. At that point, one has to assume that some targeted tax increases will be coming, at least if the current political backdrop remains.
5) Will interest rates start to rise with all the new borrowing and/or the credit rating downgrade?
The straightforward answer is “no”. It’s notable that 10- and 30-year GoC bond yields actually managed to dip further in the days after the Fitch downgrade (albeit by a bit less than Treasury yields slid). This included a near-record low for the 10-year yield, before a small rebound, and 30-year yields close to just 1%. And that’s even with Finance Minister Morneau mooting about leaning more to longer-term issuance. This simply drives home the reality that financial markets tend to be far ahead of ratings agencies, providing their own version of relative ratings in real time.
While we look for some modest upward drift in bond yields over the next year as the global economy gradually recovers, any major move in rates seems a long way off. The Bank of Canada has a variety of policy options at its disposal to make sure that yields don’t lurch higher, and potentially threaten the recovery. In order of likelihood, the Bank could potentially: a) re-introduce explicit forward guidance (something former Governor Poloz eschewed); b) intensify bond buying; or, c) introduce yield curve control/caps (as the Bank of Japan and the Reserve Bank of Australia have done). Given the likelihood of a still-wide output gap, muted core inflation pressures, and the wide variety of potential BoC tools, we suspect that any back-up in yields won’t last long. The net result of the pandemic for rates will most likely be even lower for even longer, a critical element in containing the fiscal costs of supporting the economy through this extremely difficult episode.