Here’s a Suggestion Mr Carney

The governor of the Bank of Canada Mark Carney has again continued to scold and give lessons to Canadians. He does this in his Monetary Policy Report of April 2012 where he reiterates some of the comments this blog criticized in a previous post. Those comments were that Canadian exporters needed to retool and refocus and that Canadian consumers needed to slow their pace of debt accumulation. The focus of the ‘retool, refocus and retrain’ mantra is largely advocated so as to increase Canadian firm’s ability to compete internationally and export. While this blog has already stated its objection to paternalistic economic communication from government institutions towards the private sector, this blog does accept Carney’s view that Canadian prosperity is underpinned by healthy trade numbers and international competitiveness. There is one criticism the Governor could have levelled that balances private sector independence and improved competitiveness, that critic should be less debt supply and it should be levelled at governments.

Talk of trade competitiveness unfortunately always boils down to currencies. In Canada manufacturers and commentators are always complain about the high Canadian dollar and how many jobs it kills. Leaving aside the fact that a high currency has as many benefits for a country as it has costs, a currency artificially above its equilibrium (or below it for that matter) is however  a concern. Let’s assume that the Canadian dollar is artificially overvalue, who might the culprit be for this imbalance? The Loonie isn’t a reserve currency so that can’t be it. Contrarily to McGuinty’s opinion oil isn’t to blame either. As the Central Bank report notes, Canadian oil is sold at a steep discount to certain international oil benchmarks, meaning that eastern Canada imports at high prices while the west exports at cheap prices, so the impact of higher oil prices only marginally affects the Canadian currency. In any case studies have refuted the claim of the Loonie being a petro-dollar. So who exactly is contributing to the Canadian dollar remaining above par with the US dollar?

To answer that question the certain economic facts need to be reviewed. Commentaries on trade and currencies often emphasize a restricted number of causes for currency fluctuations. Currency movements need to be understood in terms of foreign exchange market equilibrium. Every currency trade impacts the prevailing exchange rate but every trade does not just involve a quick speculation or an oil contract purchase. Much purchasing and selling of currencies involves savings diversification by institutional money managers. To give some colour to this point in 2007 before the crisis hit, foreigners shed roughly ~10 Billion of government paper while exporters sold just over 460 Billion dollars of exports. Since the beginning of the crisis over 400 Billion of Canadian government financial papers have been sold to foreigners. What does all this mean? Government budget surplus reduces the supply of government debt available to foreigners for purchase, a government deficit increases the supply. Since foreigners must buy Canadian dollars to purchase both export goods and government debt, Canadian governments’ profligacies are partially to blame for the high Canadian dollar. Part of their issuance of debt has been sold to foreigners increasing the demand for the Loonie and crowding out exports of goods and services.

Some might be tempted to point to Europe to refute these assertions. They would note Europe’s deficits have widened since 08 while the Euro has generally fallen. This is easily explained by sovereign risk. Canadian government debt is perceived to be a safe investment while much of the Euro area’s debts are considered very risky. Investors the World over generally prefer to buy Canadian debts than those from the PIIGS as they could be described as better quality products. Essentially Canada’s two most popular exports have now become oil and debt, small wonder manufacturing in Ontario can’t keep up. So if Mark Carney is so considered with the twin problem of profligacy and competitive weakness why isn’t he calling for Government austerity?

A Conservative Budget

Minister Flaherty scratching his shoe instead of his head

This was probably one of the more tame federal budgets in decades. Although it may be spilling a lot of ink now, expect the upheaval to be very short lived. While the Opposition may pay a little more attention than most to the budget, it is so unremarkable that they will probably return to criticizing such bills as C-10 and C-30 and keep the focus on the Robocalls scandal. As unremarkable as this budget may be, like all budgets it deserves much scrutiny for what was in it, what wasn’t and why its measures are so incremental.

Before we begin scrutinizing the budgets fine print, it must be said that the budget speech had one element in it deserving much praise. Rising up in the house of Commons to deliver his budget, Finance Minister Jim Flaherty spoke often of Canada’s fiscal leadership among industrialized nations. He noted recurring that Canada led the G7 in some manner or form when it came to public finance. Something in the rhetoric changed. After lavishing his government with much praise he proceeded to explain that Canada could not only benchmark itself against the wealthiest nations of the World, but should also compare itself with the ‘fastest’ and most dynamic growing nations of the World. It seems that if anything the conservatives have at least learned that comparing oneself to the wealthiest is no sign of merit when they are the economies that are the most stagnant in the World. This kind of talk can only lead to policy better aligned with the realities of the 21st century World dynamic.

Moving on to some of the less praise worthy moments of yesterday, let’s look at some of the new policies introduced and their short comings. In an effort to fill the glut of job openings in the western provinces the federal government will move to enhance immigration matching. The intentions of the action are praise worthy, the means may also be effective and fair, however one solution has not been explored. Employment insurance in Canada is atomized. While the program is national in scope and the premiums equal in all provinces, the hours contributed necessary for eligibility vary widely across regions, payout lengths are also regionally discriminatory. The result of this is while unemployment remains elevated in eastern Canada, job openings go unfilled in the west. Canada’s EI system encourages Canadians not to move to seek employment it encourages regional structural unemployment. So while the Premier of Saskatchewan is off in Ireland to go recruit that countries skilled unemployed labourers Newfies sit at home cashing in the dole waiting for the fishing season to start again. With standardization of EI across Canada the government could have hit two birds with one stone: reduce lost output in the west because of labour shortages and reduced unemployment in the east because of -job shortages. Than economist say they are puzzled with Canada’s international un-competitiveness, simply shameful.

Another issue Minister Flaherty often raises is the problem of an over heating real-estate market. No signs of cooling down the next Canadian Bubble. While almost all agree Vancouver and Toronto’s markets are over heating and the country is building condos at a breakneck pace, the minister choses to do nothing about it in his budget. The simplest and most efficient way to calm down the real estate market AND reduce the deficit would have been to phase out interest deductibility. This would in a sense incentivise the deleveraging of the entire Canadian economy which could have adverse effects on output if implemented too fast. A measured and gradual elimination of interest deductibility would reduce the tax incentive to speculate with borrowed money hence reducing leverage (bad), speculation, (bad), bubbles (bad) and the deficit (bad). So in fact this could have been a 4 birds 1 stone kind of solution.

One categorically adverse proposition in the budget has to do with the new R&D regime. The current plethora of R&D programs cost Canada $3 Billion or so. The Jenkins Report submitted to the federal government essentially called the money wasteful. The report stated that the money wasn’t helping to foster technology or competitive improvements. While a simple solution would have been to scrap this corporate welfare all together and just drop the corporate tax rate proportionally to the savings, the government decided to go down another path. The Conservatives chose to transform the R&D tax credits into direct subsidies. Completely reprehensible and irresponsible. Not only will bureaucrats start picking winners and losers. The R&D programs will now be open to graft, bribery or political interference as has been seen in other jurisdictions. Canadians often admonish Americans for not emulating their successful policies. Well I think it appropriate for Americans to admonish Canadians for emulating their failures. That the federal government hasn’t heard of Solyndra, a near household name down south, is a testament to narrow vision. At least government intervention, interference and market distortion seems to stop there in this budget.

Corporate and personal taxes not part of the plan, eh? No new corporate tax rate reductions planned. This is probably the Conservatives not adding salt to their unions wounds. Why unions love corporate taxes is still beyond me, but in any case no drops in personal and corporate taxes are envisioned. This is objectionable. The corporate tax remains one of the largest sources of economic inefficiencies  and a double tax on the wealthy and middle class. Any lack of effort on this front is meritorious of its own lambasting post. Canada remains middle of the pack in the OECD in terms of corporate taxes, as the Finance Minister said himself we need to compete aggressively with the up and coming economic powers of tomorrow not the stale economies of the yesterday.

The cuts to government departments’ operating budgets are mild and inconsequential to say the least. As has been mentioned by other commentators, the cuts in civil service employment levels do not even match the Conservatives hirings since 2006. Canada will still be saddled with more bureaucrats than before the Conservatives took office. The planned yearly operating efficiencies of $5.2 Billion. When Canadians were being fed numbers between 4 and 10 Billion dollars the actual number is only conservative in its timidity and aversion too splashiness. In terms of defining themselves as fiscal conservatives, the governments efforts are halfhearted at best. Some of the long term efforts at spending consolidation deserve applause: OAS change from 65 to 67, enhanced OAS benefits after 70 and all civil servants increased pension plan contribution. The short term efforts leave many, including the Canadian Taxpayers Association, short of admiration.

One important announcement, although not budgetary in nature, will surely get greeno Mulcair riled up. The government’s plan to cap all environmental reviews to 24 months (thats two whole years for those not paying attention) is a great boon to Canada. Let’s just admit it their is no reason (even for environmentalists) to want businesses to expand resources, government bureaucrats to waste time and the Canadian economy to lose steam just so that great business projects get merely slowed down by our overly stringent and public review system. That’s not to say that when talking about Canada’s pristine Wild we should all be environmentalist, but when an energy project is good and going to get approved anyway why waste everybody’s time. Seriously Green Peace, the Oil Sands may be bad (I didn’t say are, I said maybe) they’re a bleep in the environments radar, you should be scared of China’s industrialization, not northern Alberta’s botox gone awry.

The bottom line is that this is a timid, non-game changer budget. This is not how to win fiscal conservatives votes. This is not how to improve fiscal or macro-prudential policy. None the less it’s not a terrible budget, there is more good than bad. Let’s hope this budget is popular enough to convince people to let the Conservatives do what they got elected to do: Make government smaller!

Shout out to our Malaysian readers,

Cius

Sonnez l’Alarme!

So I keep hearing that Quebec’s fiscal situation is not alarming, that austerity drives are not necessary and that the Jean Charest Liberal government is in the pocket of ‘Big Business’. So I did some snooping around and some number juggling to investigate whether the government’s current drive for a balanced budget is reasonable or just neo-conservative ideological pandering.

So I had to crunch some numbers a little and here is what I have found:

Often you hear people say our situation is not bad we are middle of the pack in the OECD in terms of net debt. Alright so having taken StatsCan’s number’s for Quebec’s net debt than adding on its proportional share of federal government net debt, Quebec indeed is middle of the pack. But who exactly is in the OECD you ask? Well out of 31 countries in the club of developed nations 5 have accepted IMF or EU bailouts (Greece, Hungary, Iceland, Ireland and Portugal). Another 4 countries (Belgium, France, Italy, Spain) have come close to being shut out of credit markets or seen the spead between their yields and comparable safe haven bonds increase to historical highs*. Many more OECD members have seen their long term credit ratings cut since 2007. All this to say that benchmarking ourselves against the OECD is just plain deceptively simplistic. Looking at the chart, one can see that Quebec is also middle of the pack of those that were bailed out. Bigger countries like the US, UK and Germany can get away with higher debt levels, it’s the nature of capital markets to respect bron over brain. However small countries need to be prudent. Ireland and Iceland had very small debt burdens before the crisis and look where they are now: bailed out and battered.

Now that we’ve established that Quebec is part of an unenviable club of high debt small countries, let’s look at its particular situation and find out why people still think things are okay. First sign is bond yields. Quebec’s 2 year bond is yielding ~1.35% or approximately 35 basis points above the Central Banks key rate. In the US the 2 year yield is roughly 27 basis points (at friday march 2nd close) or ~25 basis points above its target rate. So Quebec isn’t borrowing in real terms much more expensively than the US government, allegedly the safest debtor in the World (not that I believe they should be). Another indicator that would suggest no immediate problem is Quebec’s credit rating.

Moody’s	Aa2 (stable)	P-1
Fitch Ratings	AA – (stable)	F1 +
Standard and Poor’s	A + (stable)	A-1 +
Dominion Bond Rating Service	A high (stable)	R-1 (middle)

 None of Quebec’s credit ratings are Prime, meaning Quebec isn’t the safest bet possible but they remain in the High Grade to Upper Medium Grade categories. So one could be forgiven for believing that Quebec is fiscally alright given that large swaths of the financial and capital markets community still respects Quebec’s ability to service its debt. Now you are probably wondering why the ratings agencies are so kind to Quebec. There are many reasons why Quebec might be more financially than the European periphery or developing nations, I’ll focus on the three that seem most important to me (and probably the credit rating agencies):

   Firstly, according to the Canadian Constitution property rights and natural ressources are a Provincial jurisdiction. In essence the Quebec government can legislate any which way it wants with regards to natural ressources. Nationalisation, royalty regime changes and taxation are weapons the government can use to raise revenues or assets. These circumstances are what led the Quebec government to own one of the largest utilities in the World (Hydro Quebec). This coupled with the fact that the Province has a land masse of over 1.5 Million square kilometers containing an abundance of mineral and hydrocarbon ressources puts it a notch above the failing states of Europe in terms of natural wealth endowment.

   Secondly, the province’s government has a relatively high liability coverage ratio. That is for every dollar of debt the government owes it has 51.25 cents of assets as of 2008 compared to an OECD average of 44.91 cents in the same year. Now comparing to the OECD is once again very tricky since some of the members have coverage ratios in the triple digits while others have miserable ratios.

   Lastly, Quebec has an immense advantage over the PIIGS in that, it is part of a functioning monetary and fiscal union. Now functioning is very relative but it works great for Quebec. Quebec’s budget is partially immune to boom bust cycles because some of the automatic stabilizers are federal responsibility. For exemple Unemployment Insurance (called EI in Canada) is covered by the federal government. Quebec is also the recipient of fiscal adjustment transfers. Currently just above 10% of the Quebec budget expenditure is paid for through fiscal transfers from the federal level. This means very simplistically that the government can afford aheftier debt services payments oft least 10% more than its peers (if not much more).

The preceding points and the second graph would seem to imply that the province has the means to pay down its debt and that it has done so since the middle of the 1990’s. However from the third graph (Can & Qc Budget Balances) it is obvious that much, if not all of the heavy lifting in terms of debt consolidation has been done at the federal level. Another factor that has led to a decrease in the overal debt load is the shrinking share of the federal government debt. The data presented here takes into account a generational decrease in Quebec proportion of the debt do to a decreasing share of the population, from 26.38% in 1981 to 23.14% in 2011. The decreasing share of population indicates another problem is present. Quebecers are no longer making babies (okay they still are just not a lot). Quebec is well beneath the population replacement ratio of 2.1 children per woman (~1.5 last I checked, even though we are in the midst of a little echo boom). Which means that the labour participation rate is headed down way down in a near future.

Admittedly that problem isn’t quit immediate and can always be buffered by laxer immigration policy.

Remains the elephant in the room: the gross debt. Not a lot of countries can claim higher gross debts than Quebec without terrifying bond investors or having the IMF knocking on your door. I’ve explained above why this might be, now I’ll explain why it might not last. The bail out situations varied from country to country, but in Ireland and Iceland’s cases it was a question of nationalizing banks then watching the asset side of the balance sheets evaporate, net debt quickly rose towards the gross debt levels. While this isn’t likely to happen to Quebec (most Canadian banks are safe and headquartered in Ontario) it isn’t impossible either. A likelier problem would be a repeat of the Caisse de Depots et Placements 2008 kapoot, when it saw its assets shrink in value, creating a massive unfunded pension liability for the government (one is already present but most actuaires say it is manageable). Mis-management of state enterprises ‘a la Grecque’ or PDVSA style seems quite possible to me in the long run. With Hydro Quebec being the most indebted corporation in Canada (over 35 Billion $) and paying out a heavy dividend to the government its book value should be higher but isn’t. Also not to be neglected is secession from Canada. While politically unlikely now, it wasn’t so long ago that a referendum was won to preserve the confederation by a voting margin of less than 1%.

The bottom line is that Quebec is viewed as stable for a few good reasons, however neglecting the fact that Quebec is as financially precarious and politically unmanageable as some of the worst developed World debt offenders. Buy Quebec debt at your risk, within the next ten years austerity will become an obligation not a choice, I’m not hopeful that our politicians and the citizens they represent will show themselves more responsible than their Greek equivalents.

P.S. Thank you to all those who voted NO to seperation in 1980 and especially in 1995. Quebec would look like a colder version of Greece or Ireland right now if it wasn’t for your assiduousness.

* By “historical highs” I mean Euro era historical highs versus comparable German Bunds yields.

Drummond to Ontarians with Love

Don Drummond ex chief economist at the Toronto Dominion bank, the second largest in Canada, came out this week with a report this week on how Canada’s most populous province could tackle its mounting deficit. since most of my friends are neither Ontarians nor Canadian economic history buffs I feel that the significance of this past week’s event merits a little historical context.

Now this context starts somewhere around the 1800’s but bear with me for a while it won’t be that long. At the inception of Canadian confederacy political and economic clout were concentrated mostly into the two most populous provinces, Quebec and Ontario. These provinces were the bedrock on which Canadian economic growth rested and the springboard for much of Canadian political development. Around the mid 20th century Quebec relinquished its place as a driver for Canadian development leaving Ontario as the sole anvil on which the expansion of Canada could be forged. Business and industry migrated from Montreal to Toronto leading the latter to surpass the former in terms of population, economic output and general clout around the 70’s. As Ontario’s population soared the province became the capital for the financial industry and the center of canadian manufacturing. With its growing presence Ontario played the part of the peace broker in Canadian politics funding welfare programs across the country. 

That’s when things started changing. In the 90’s the cut in transfer payments from the federal government coupled with the pan-Canadian drive for budgetary surplus led to the Harris Year’s at Queen’s Park (unofficial name of the seat of Ontarian government). These years were marked by fiscal consolidation and labour wars with unions. Although mostly recognized as sensible policy actions by most non-union circles, the Harris years created a backlash which ushered in the McGuinty years. This conciliatory leader brought in accrued social spending, bought labour peace and spent his way to three election victories from 2003 till present. This unloosening of the public purse however led to a gaping deficit following the recession of 2009-10. So in 2011 facing an upcoming election and with plenty of deficit and debt accumulation to justify McGuinty called on Don Drummond a well respected economist to propose ways of reforming government expenditure and services to enable the province to return to budget balance by 2017-18 without raising taxes.

A year later here we are, and with the McGunity in government reduced to minority status the Drummond reports has just hit the shelves weighting in at ~320 proposals and 540 pages. To most observers the report while impartially worded comes in as a heavy rebuke to the years of government largess. The headline proposals are to get rid of some of the Premier’s pet projects like supporting alternative energies, all day daycare reform if not get rid of most forms of corporate welfare and finally to steal a page from the Harris playbook and start playing hard ball with the Province’s largest unions.

Unfortunately this is not Italy and the credit markets have not yet come for McGuinty’s profligate head… yet. Hence This technocratic gem of a report will certainly not become law. The government has already announced it will preserve the expensive all day daycare program. Most observers agree the prescription no matter how impartial, how well crafted or how sensible are politically unpalatable for the Liberal Government. So don’t expect Ontario to resume its role of Canadian growth engine anytime soon, much to the contrary expect Ontario to continue to be the drag on confederation it has been for the last 3-4 years, eating up equalization payments instead of funding them.

The picture is gloomy the report itself states that economic growth will not exceed the 2% mark for the foreseeable future and has also stated the deficit isn’t expected to shrink before reaching an all time high and federally comparable 30 Billion C$. So here’s my prediction McGuinty doesn’t fix the finances but let’s them continue on their gradual slide into PIIGS style irresponsibility. So expect to see a Montiesque kind of technocratic government coming in within the next decade to fix Ontario’s rivalry with Quebec for the most shoddily run provinces in Canada prize.