Slower economic growth and higher public spending are straining Ottawa’s “fiscal anchor,” with federal government debt compared with the size of the economy expected to rise in the coming fiscal year.
Tuesday’s budget arrives in a deteriorating economic environment. After two years of rapid growth as pandemic restrictions loosened, the Canadian economy is expected to stall this year under the weight of higher interest rates. Recent turmoil in the U.S. and European banking sectors has increased the odds of a more severe downturn.
This souring outlook, combined with a raft of new spending announced on Tuesday, is undermining Finance Minister Chrystia Freeland’s commitment to keeping the federal debt-to-GDP ratio on a declining path, at least in the near term. Ms. Freeland has frequently said that a downward trend in this ratio is the government’s key measure of fiscal responsibility – its “fiscal anchor.”
The budget projects the debt-to-GDP ratio will rise to 43.5 per cent in the coming fiscal year, starting April 1, up from 42.4 per cent in the current fiscal year. It is then projected to drop in the following years, reaching 39.9 per cent in the 2027/28 fiscal year.
The budget also contains a downside scenario, capturing concerns that inflation could prove stickier than expected and that banks could pull back on lending in response to stress in the financial system. This scenario sees the debt-to-GDP ratio increase over the next two years, peaking at 44.4 per cent before falling to 41.5 per cent by fiscal 2027-28.
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“While the ramifications of banking sector stresses for the global economy are not yet clear, were the crisis to broaden, it could result in higher funding costs, restricted credit, and the amplification of the global economic slowdown,” the budget warns.
Weakening growth poses a challenge for the government as it tries to manage the country’s debt burden after spending heavily on COVID-19 programs – a task made more urgent by the rise in interest rates, which has increased the government’s cost of servicing its debts.
Federal debt exploded during the pandemic, rising from $721-billion in the 2019-20 fiscal year to $1.13-trillion last year. At its peak in fiscal 2020-21, the debt-to-GDP ratio hit 47.5 per cent, up from 31.2 per cent before the pandemic.
Since then, improvement in the debt-to-GDP ratio has been helped along by blistering economic growth, high commodity prices and the highest inflation in decades, which combined to boost nominal GDP – the broadest measure of the country’s tax base – by a massive 11 per cent in 2022. Such rapid growth in nominal GDP boosts tax revenues and means the size of government debt relative to the size of the economy shrinks.
This dynamic won’t be as favourable to the Liberal government going forward. Even before the recent banking turmoil, private sector economists surveyed by the government had slashed their outlook for both real (inflation-adjusted) and nominal GDP growth. The group expected nominal GDP to be roughly $60-billion lower, each year for the next five years, compared with their outlook in October. In the downside scenario, nominal GDP is around $100-billion lower on average each year than projected in the fall.
“What they’ve done in past budgets is they’ve shown improvements to [the debt-to-GDP ratio] and they’ve kind of patted themselves on the back … but nominal GDP, the denominator, has carried the day,” said Rebekah Young, Bank of Nova Scotia’s head of inclusion and resilience economics.
“Now they’re saying we’re going to breach [the fiscal anchor], because it’s out of our control, GDP is weaker. But I would say the implicit expectation when using a soft anchor is that it should hold in normal times, it should withstand slowing growth that we’re looking at. It should only be breached in serious downturns,” she said.
The government is not a passive observer in the deterioration of the debt-to-GDP profile. Tuesday’s budget announced another $67.3-billion in new spending over five years, which is partly offset by $21.5-billion in internal savings and tax hikes. The government is projecting deficits for the next five years, including a $43-billion deficit this year, and has no plans to balance the budget.
While a significant portion of the new spending is aimed at boosting longer-term economic growth through incentivizing investments in low-carbon technologies, that won’t do much in the near-term as the business cycle turns negative.
“I’m worried about the fiscal framework now. It’s much more shaky than it was in the fall,” said Robert Asselin, senior vice-president at the Business Council of Canada.
“There’s the worsening economic outlook, the rise of interest-rate charges, and more spending. We keep adding spending every budget, every fall economic statement,” he said.
The cost of servicing government debt remains low by historical standards, but the rapid rise in interest rates over the past year put additional pressure on federal finances. The government expects to spend $43.9-billion servicing its debt in fiscal 2023-24, which is $11-billion higher than it forecast in last year’s budget. Annual debt-servicing costs are expected to rise to $50-billion by fiscal 2027-28.
The percentage of government revenues going to debt-interest payments is expected to rise to around 9 per cent in the coming years. That’s up from a low of 5.7 per cent in fiscal 2021-2022, but well below the crisis levels reached in the 1990s. At a peak in 1995, the government was spending 35 cents for every dollar it collected servicing debts.
Jimmy Jean, chief economist at Desjardins Group, said that the government’s debt servicing costs remain manageable, although they will become a bigger burden over time.
“Recreation time is over. We’re heading into an environment where interest rates are going to be, I believe, sustainably higher than they were in the prior cycle,” Mr. Jean said.
“So this is something that they need to take into consideration, and that’s part of why we’re seeing that fiscal deterioration: because they need to incorporate both weaker economic growth and higher interest rates.”
The Bank of Canada has paused interest rate hikes, and markets expect it to start cutting rates later this year. Nonetheless, the government will have to pay higher interest rates than it is accustomed to in the coming years as it rolls over its existing short-term debt and issues new bonds.
Mark Rendell