Monday, 29 February 2016

Big Deficits, Bigger Debt: Who Cares?

Canadian governments are leaking out the bad fiscal news that comes along with slow growth and a collapse in commodity prices. The Government of Canada revealed that even before implementing the bulk of the Liberal government's spending promises made in the recent election, its projected fiscal deficit for 2016-17 has jumped to C$18.4 billion. Oil-rich Alberta's recently elected New Democratic Party Government has let slip that its projected deficit will rise to a record $10.4 billion. Newfoundland's recently elected Liberal Government has murmured that its deficit will rise to an unprecedented $2 billion (about 6% of provincial GDP).

As the bad fiscal news trickles out, many prominent Canadian economists are arguing that more fiscal stimulus is needed. Some say that a $30 billion federal deficit would be appropriate, some say $40 billion, some even say $50 billion.

They argue that Canada is in the enviable position, after almost 20 years of working down its federal government deficit and debt, of having plenty of room to add fiscal stimulus to boost an economy experiencing sluggish growth.

Personally, I don't think that allowing fiscal automatic stabilizers to push up budget deficits is a bad thing. But I do think that urging governments to increase deficits by 2 or 3 percentage points of GDP for several years carries far more risk than these economists are letting on.

Canada's Total Debt

While Canada's federal government has done a very good job of getting its' fiscal house in order over the past 20 years, Canada's total debt levels have increased dramatically over the same period. 

In 1995, Canada faced a government debt crisis. The combined gross debt of all levels of government reached 91% of GDP, with the federal government debt at 55% of GDP and other levels of government adding another 36%. At that time, Canada's total debt to GDP was 231%.

In 2015, Canada's total debt has reached 312% of GDP. While federal debt has fallen from 55% to 34%, the debt levels of all other sectors have increased significantly. Over that period, household debt has risen from 63% to 95% of GDP; non-financial corporate debt has risen from 58% to 72% of GDP; financial sector debt has risen from 19% to 69% and debt of other levels of government has risen from 36% to 42%.

Saying that Canada's federal government has plenty of room to borrow to add fiscal stimulus ignores the sharply increased debt levels of every other sector of the economy. Just looking at the government sector, it doesn't appear that the situation in 2015 is much better than it was in 1995.

Total government debt at the end of 2015 was 76% of GDP, up 24 percentage points from the recent low of 52% in 2007.  Over the past 55 years, only during Canada's government debt crisis period, which began in 1991, did total government debt exceed the level it reached in 2015. 

How Does Canada's Debt Compare?

The world is awash in debt. How does Canada compare with other countries? In 2015, the McKinsey Global Institute published a revealing study titled Debt and (not much) deleveraging. The chart below shows, on the left, McKinsey's breakdown of total debt to GDP in 2Q14 for the global economy, USA, Germany, China and Canada; and, on the right, Statistics Canada's breakdown for Canada in 2Q14 and the most recent data for 3Q15.

The comparison shows that in the McKinsey study, Canada's total debt to GDP, at 247%, was significantly higher than the global average but slightly lower than Germany (258%), USA (267%), and China (269%). Statistics Canada data, from the National Balance Sheet Accounts, shows Canada's total debt to GDP was somewhat higher in 2Q14 than the McKinsey estimate, at 287%, mainly because of a higher estimate for the debt level of financial corporations. StatCan's measure of Canada's total debt to GDP for 2Q14 is higher than the McKinsey estimates for the USA, Germany or China, in large part because of the high level of household debt. StatCan's most up-to-date estimate shows Canada's total debt to GDP has surged to 312% in 2015, reflecting increases across all sectors, but with the biggest jump in the non-financial corporate sector. A good part of the increase in corporate debt was to fund expansion in the energy and other commodity sectors of the economy when commodity prices were high.

Those economists who are encouraging the federal government to undertake stimulus to push the federal deficit up to $30 billion, $40 billion, or $50 billion are saying that the government has plenty of room to run bigger deficits. When the additional $20-30 billion deficits of the provincial governments are added, total government deficits could reach 3% to 4% of GDP over the next few years. This would push Canada's total government debt to GDP back above 80%, the level that marked the beginning of the government debt crisis of 1995. And it would come at a time when Canada's total debt to GDP was nearing 320%, compared with 230% in 1995.

Debt and Growth

A 2011 Bank for International Settlements (BIS) paper, titled The real effects of debt, summarized their research as follows,
At moderate levels, debt improves welfare and enhances growth. But high levels can be damaging. When does debt go from good to bad? We address this question using a new dataset that includes the level of government, non-financial corporate and household debt in 18 OECD countries from 1980 to 2010. Our results support the view that, beyond a certain level, debt is a drag on growth. For government debt, the threshold is around 85% of GDP. The immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems. The longer-term lesson is that, to build the fiscal buffer required to address extraordinary events, governments should keep debt well below the estimated thresholds. Our examination of other types of debt yields similar conclusions. When corporate debt goes beyond 90% of GDP, it becomes a drag on growth. And for household debt, we report a threshold around 85% of GDP, although the impact is very imprecisely estimated.

In the detail of the research, the authors report, "we see that public debt has a consistently significant negative impact on future growth. And, the impact is big: a 10 percentage point increase in the ratio of public debt to GDP is associated with a 17–18 basis point reduction in subsequent average annual growth [over the next 5 years]". In Canada's case, this suggests that the 24 percentage point rise in total government debt since 2007 could already be responsible for slowing real GDP growth by almost 0.5% per year. And the sharp rise in household and corporate debt is likely acting as a further drag on growth. 

Kenneth Rogoff and Stephanie Lo argue in in their 2014 BIS paper, that their leading candidate for the sluggish growth in the period since the financial crisis is the overhang of debt across all sectors of the economy. They argue that "these debt burdens need to be analysed in an integrative manner in order to assess the extent of an economy’s vulnerability to crisis or, in the case of advanced economies, the impact of higher debt on potential growth". They cite research that suggests "the impact of debt on growth in any given sector – whether it is government, household, or corporate – is worsened when other sectors also hold high debt. Therefore, an economy’s overall debt level and composition matter, both because private defaults can create contingent liabilities for the government and because there can be amplification mechanisms across sectors that exacerbate the negative effect of debt on growth. (For example, if private sector defaults lead to weaker growth, this affects the sustainability of government debt; if households are suffering debt problems, this can lower demand and can lead to strains in corporate debt)".

Another 2014 report, Deleveraging? What Deleveraging?, by Luigi Buttiglione, Philip R. Lane, Lucrezia Reichlin and Vincent Reinhart, surveys the inexorable rise in global debt to GDP across all sectors and concludes,
We observe a poisonous combination – globally and in almost any one geographic area – between high and higher debt/ GDP and slow and slowing (both nominal and real) GDP growth, which stems from a two-way causality between leverage and GDP: on the one hand, slowing potential growth and falling inflation make it harder for policies to engineer a fall in the debt-to-GDP ratio, and on the other hand attempts to delever both the private sector (especially banks) and the public sector (through austerity measures) encounter headwinds, as they slow, if not compress, the denominator of the ratio (GDP).


After the G20 meeting in Shanghai last week, Canada's new Finance Minister Bill Morneau said, "I received very positive feedback on Canada’s new path for long-term growth"... and added that the March 22 budget “will demonstrate Canada’s commitment to making smart and necessary investments in order to grow the economy." However, the Financial Times reported that G20 finance ministers clashed over the wisdom of additional fiscal stimulus. The FT quoted Wolfgang Schäuble, German finance minister, as saying from the sidelines the Shanghai meeting, "The debt-financed growth model has reached its limits. We therefore do not agree with a G20 fiscal package as some argue … There are no short-cuts that aren’t reforms."  

While many prominent Canadian economists have supported larger deficits, they do not seem to have considered the impact of bigger deficits on Canada's total debt to GDP and the consequences of record high total debt levels for medium and longer term growth. This is a particularly important at a time when Canada is facing the largest, most rapid and potential longest lasting deterioration in its terms of trade in decades -- itself a serious blow to Canada's GDP and it's capacity to support its' high level of total debt. 

In my opinion, this is an environment in which great caution is required in the formation of fiscal policy. In particular, fiscal measures that contribute to a lasting increase in structural budget deficits at either the federal or provincial level should be avoided. Government deficits will rise; automatic stabilizers should be allowed to work; some infrastructure spending that supports private sector growth should be undertaken, temporary tax incentives to encourage private sector investment could also have a positive short-term effect without increasing structural deficits. But large increases in federal and provincial government budget deficits -- at a time when the debt of other levels of government and the private sector are at record highs -- would pose a significant threat to Canada's longer-term economic growth and stability.

Monday, 15 February 2016

The Bond Market is Talking: Is the Bank of Canada Listening?

Don't get me wrong. I am not complaining that the Bank of Canada didn't take my advice last month to cut the policy rate. It was a close call. Many Bay Street analysts were frightened that a rate cut could trigger a currency crisis. The national media was focussed on the impact of a weaker Canadian dollar was having in pushing up imported food prices and the cost of Florida vacations. 

The January decision fell on the same day that rookie Prime Minister Justin Trudeau was making his maiden appearance at the  Davos World Economic Forum, telling the world that he wanted Canadians to be known "for our resourcefulness" rather than for our resources. Cutting the policy rate on the same day might have been a disconsonant signal for the Bank of Canada to send when Trudeau was assuring the world that "Canada has something else that isn’t so easily quantifiable. Confidence".

I have been very supportive of the BoC's actions since they began cutting the policy rate in January 2015. The Bank responded in a timely and appropriate fashion to the plunge in Canada's terms of trade that began in the summer of 2014, cutting the policy rate in two 25 basis point steps in January and July to it's current level of 0.50%. I recommended a further cut in January because commodity prices and Canada's terms of trade had continued to fall sharply. Prior to the decision,  I noted that "if the BoC decides not to cut rates the Canadian dollar will likely rally, preventing it from acting as the cushion to the terms of trade drop that it needs to be". That is exactly what has happened.

In the January 20 press conference that followed the Bank of Canada decision to leave the policy rate unchanged, Governor Stephen Poloz listed three considerations that led the Bank not to act on its "bias toward further monetary easing". These included:

  • Information on the size, type and timing of federal fiscal stimulus was not yet available. The BoC preferred to wait until the Federal Budget is tabled to get a fix on how fiscal stimulus might accelerate the return to full capacity in the economy, which the BoC estimated would be "late 2017 and perhaps later", a "significant setback" from it's October projection.
  • Depreciation of the Canadian dollar since October 2015 would add considerably more stimulus to the non-resource sectors of the economy than previously projected, although it could take up to two years for this effect to be fully felt.
  • A further rapid depreciation of the Canadian dollar "could push overall inflation higher relatively quickly. Even if this is temporary, it might influence inflation expectations."

In the Q&A portion of the press conference, Poloz elaborated on the risk that inflation expectations could rise if the the C$ fell rapidly and pushed up prices of imported goods. However, he stated:
"We don't think that's happening. We believe inflation expectations are very well anchored on 2% after 25 years of successful inflation targeting. But that is a consideration that we need to bear in mind when the exchange rate is moving quickly".
Later in the Q&A, Poloz noted that how the Bank reacts to Canadian dollar weakness in the future would depend on the context. If the C$ were falling for no apparent reason, that would be a concern. But, he noted, "If the oil price is going down some more, that's another negative for the Canadian economy, and so the dollar is doing part of the adjusting for us".

The BoC Monetary Policy Report suggested that another possible rationale for not cutting the policy rate was "highly stimulative" financial conditions, adding that "reductions in the Bank’s policy interest rate in January and July 2015 contributed importantly to these accommodative financial conditions".

The Bond Market is Talking...

One of the best ways to assess the effect of monetary policy actions (or inaction) is to look at how the bond market responds. We can look at the spread between nominal and inflation-linked bonds as an indicator of inflation expectations. We can look at movements in the yield curve as an indication of the markets real GDP growth expectations. And we can look at credit spreads as an indicator of financial conditions.

The chart below shows Canada's breakeven inflation rate as measured by the spread between the yield on nominal long term Government of Canada bonds and the yield on the Canada Real Return Bond (RRB). The breakeven inflation rate is a market-based measure of expected inflation.

While Governor Poloz cited a risk of a rise of inflation expectations, the bond market is saying that the real risk is that inflation expectations could become unanchored from the 2% target on the downside. The latest market based estimate of inflation expectations, the breakeven rate, has fallen steadily since the summer of 2014 to just 1.29% on February 11. The BoC responded to downward moves in inflation expectations with two rate cuts in 2015, but has not yet responded to the further decline in 2016.

The next chart shows the Canadian yield curve, measured by the spread between the Government of Canada 10-year bond and the 2-year bond. A higher spread, i.e. a steeper yield curve, is a market based indicator of stronger expected real GDP growth. A flatter curve indicates expectations of weaker growth ahead.

Governor Poloz was upbeat on growth prospects, anticipating that actual GDP growth will exceed potential growth in 2016 and 2017, causing the economy to return to full capacity. But the yield curve has flattened significantly since the beginning of 2016, suggesting that market participants are anticipating slower growth ahead. The bond market is expecting a larger dose of fiscal stimulus in the 2016 federal budget than the new Liberal Government promised during the election campaign, but still expects growth to slow further.

A third message from the bond market is that financial conditions are tightening despite the monetary easing supplied by the BoC in 2015. The chart below shows the spread between investment grade corporate bonds and the Government of Canada bonds of similar duration. 

Source: Barclays

The corporate spread has widened since the summer of 2014 by almost 90 basis points and is wider than at any time over the last decade with the exception of the credit crisis of 2008-09. Wider spreads reflect higher risk premia on corporate debt and tighter financial conditions for business. Further evidence of tighter credit conditions is provided by Bank of Canada data on the effective borrowing rate on business loans, shown in the chart below.

The interesting aspect of this chart is that, while the effective borrowing rate fell when the BoC cut the policy rate in January 2015, it actually rose after the second rate cut to 3.12% by early February, virtually unchanged from where it was before the BoC began cutting the policy rate.

In summary, the bond market is telling quite a different story from the one used by the BoC to justify remaining on hold on January 20. The market, via the breakeven inflation rate, is saying that the risk to inflation expectations is that they may be becoming unanchored from the 2% target on the downside, not the upside, with market-based long term inflation expectations falling to just 1.3%.  Through the yield curve, the bond market is saying that expected real GDP growth is falling, not rising, in spite of expected greater fiscal stimulus. Through the corporate credit spread, the market is saying that financial conditions are tightening, not easing, and have reached levels not seen outside the credit crisis of 2008-09. 

... Is the Bank of Canada Listening?

Since the BoC decided not to move on January 20, much has transpired. 

  • Crude oil prices, which opened the year at US$37 per barrel, have fallen below US$30/bbl, or by another 20%.
  • Amidst financial market turmoil, other global central banks have eased policy further, either by moving to more deeply negative policy rates (ECB, BoJ, Sweden's Riksbank) or by tempering policy rate guidance (US Fed).
  • The Canadian dollar has rallied as other central banks have eased their monetary policy stances, trading today about 5% higher than just before the Bank of Canada decided to leave the policy rate at 0.50%.

The decision by the BoC to stand pat contributed to the appreciation of the Canadian dollar while the oil price and the terms of trade have weakened further, inflation expectations have taken another sharp step down, the yield curve has flattened indicating weaker expected real GDP growth, and the corporate spread has widened pointing to tighter financial conditions.

To be fair, the BoC could not have been expected to anticipate these recent developments. But these developments point out the potential costs of waiting for the federal budget, which is unlikely to bring any major surprises for the markets. The BoC would likely have preferred not to have to deal with a further drop in oil prices, financial market turmoil, and shifting foreign central bank policies. However, they are now a part of the macro environment that the BoC must take into account as it decides whether to stand pat again on March 9.