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Tough fiscal choices ahead for provinces Print E-mail

Oct 18, 2010 Barrie Mckenna

Think of a couple who are just barely getting by with a big mortgage, flat incomes and twins on the way.

Then interest rates start creeping up.

Now you have some idea of the looming threat facing Ontario, Quebec and other heavily indebted provinces. They’re scraping by now, thanks to all the cheap money flooding into the North American sovereign debt market. Low interest rates have a way of making even whopping debts seem manageable.

But the provinces’ fiscal health is tethered to forces largely beyond their control. The kinds of struggles faced by Greece, Spain, Ireland and others could quickly cross the Atlantic, forcing some provinces to make tough and painful fiscal choices – cut teacher salaries, close schools, fire nurses, or hike taxes to pay for it all.

“The notion of what’s a safe risk can change quickly,” warned economist William Robson, president and chief executive of the Toronto-based C.D. Howe Institute. “It’s very likely there will be a change in peoples’ views of North American bonds.”

Higher perceived risk could lead to higher interest costs for provinces. Mr. Robson said the fiscal challenges facing the provinces, and particularly Quebec and Ontario, will “come into sharper focus in bond traders’ minds as interest rates go up a bit.”

Ontario is the most at risk because of its sheer size, and its record deficit. Economists warn that the province is going to have to make some tough choices in its next couple of budgets to avoid becoming the Greece of the Great Lakes.

Ontario is looking at a deficit of nearly $20-billion this year, or 3.4 per cent of GDP – higher than it has been since the early 1990s, according to Toronto-Dominion Bank estimates.

Quebec’s deficit is significantly smaller at $4.3-billion in 2009-2010, or 1.4 per cent of GDP. But its tax rates are already higher, giving it less room to manage rising expenses.

This isn’t the mid-1990s, when several provinces hit a debt wall, exacerbated by steeply rising interest rates and serial credit downgrades. But experts warn that the trend line is worrisome, particularly for the provinces that depend on the stalled U.S. economy.

Many provinces are on a fiscal track that simply isn’t healthy, or sustainable. Like that indebted couple, revenues are flat and demand for government services is cresting as the population grows and ages.

“If one province gets in trouble, the contagion will spread to others, and investors will treat all provinces the same,” said Brian Bethune, an economist at IHS Global Insight in Toronto. “That’s what happened to Spain after the crisis in Greece.”

“Provincial budgets are going to become problematic if the economic recovery doesn’t improve,” Mr. Bethune warned. “The chickens are going to come home to roost.”

In Ontario’s case, “you’ve got an emerging problem, precipitated by increasing demand for health care, social services and education,” Mr. Bethune said. “They’re barely able to keep up with it.”

Federal Finance Minister Jim Flaherty provided a hint this week of the fiscal challenge ahead. As he released his fiscal update, he suggested that the kind of generous – and automatic – increases in transfer payments to the provinces for such things as health and education may not be in the cards when Ottawa does its next deal with the provinces, for the years 2014 and beyond.

Credit rating agencies, meanwhile, are taking a much harder line with provinces and other big borrowers, after being widely criticized for not moving quickly enough during the credit crisis. Last week, Standard & Poor’s Corp. cautioned New Brunswick that its double-A-minus credit rating – already one of the lowest among the provinces – could be knocked down even further due to deteriorating budgetary conditions. The province’s deficit is on a course to hit 2.7 per cent of gross domestic product this fiscal year – the highest ratio in two decades.

Demographic shifts are also straining the spending capacity of most provinces. Canada is aging rapidly, pushing up health-care costs. Meanwhile, the demands on the education system are mounting as people move from the inner cities, where many older schools are, to the burgeoning suburbs and exurbs, where young families increasingly choose to live.

“The thing that looked a long way away is now upon us,” Mr. Robson pointed out. In a recent study, he estimated that provinces would have to slap an average $2,100 a year tax on every Canadian to cover the future costs of the health, education and various social programs they deliver.

TD economist Sonya Gulati said investors are going to be closely watching budgets next year in Ontario and Quebec for evidence of credible plans to get back to balanced budgets. “Markets will look for commitments,” she said.

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