Budget improves debt consolidation pace, but warns of economic uncertainty

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The federal government is promising to put the country’s finances on a solid footing after a period of explosive spending growth, while warning that the pace of fiscal consolidation could be knocked off course by growing global economic turbulence.

Thursday’s budget starts from a better place than expected, with the 2021-22 fiscal year deficit coming in at $113.8-billion, around $30-billion better than expected in the government’s December update. This is the result of rapid economic growth coming out of pandemic lockdowns alongside blistering inflation, which has pushed up prices for consumers but also put more tax money in the government’s coffers.

Deficits are projected to shrink over the next five years, and the federal debt-to-GDP ratio is expected to fall steadily to 41.5 per cent by 2027 from 46.5 per cent in 2021.

Kelli Bissett-Tom, Canada rating analyst at Fitch Ratings, said the federal government’s debt reduction trajectory is trending in a positive direction. At the same time, the government still has a long way to go in consolidating the massive amount of debt accumulated during the pandemic, she said.

“Given the level of federal debt right now, we’re unlikely to see rapid consolidation. But certainly this [budget], in conjunction with more positive than previously budgeted results from the provinces, … is supporting a gradual, but better than previously expected, downward trajectory,” she said.

In 2020, Fitch downgraded Canada’s credit rating one notch to AA+. Other debt rating agencies, including S&P Global Ratings and Moody’s, have maintained their highest-level rating for Canada.

The government’s debt path comes with caveats. Crucially, the global economy is entering a period of elevated volatility as a result of rapid monetary policy tightening and heightened geopolitical uncertainty, which could knock the fiscal path off course.

Central banks have embarked on the most aggressive interest-rate hiking cycle in decades in an effort to tame high inflation. At the same time, the war in Ukraine has pushed commodity prices sharply higher and disrupted supply chains that are still dealing with challenges caused by the COVID-19 pandemic.

The government’s central economic scenario is based on a survey of private-sector economists conducted in February. These numbers look increasingly out of date given Russia’s invasion of Ukraine, and the hawkish shift from central banks over the past month.

The rapidly changing economic outlook led the government to include two alternative scenarios in the budget. In the downside forecast, if the war in Ukraine drags on and central banks turn hyper aggressive on interest-rate hikes, this could spur a major economic shock that could shave close to two percentage points off real GDP growth in 2022 and 2023 and raise unemployment by 0.7 per cent. That would put the debt-to-GDP ratio back on an upward path for several years, before starting to fall again.

Rebekah Young, Bank of Nova Scotia’s director of fiscal and provincial economics, said that this downside scenario is unlikely, given that Canadian household balance sheets are generally in good shape coming out of the pandemic. But she said the government is right to be thinking of downside risks.

“It speaks to the challenge of creating a budget at this time, because you can think of many possible events that could happen. We now have global conflict, we still have a pandemic. We have runaway inflation and this policy risk, so there are easily five different scenarios that are less desirable,” Ms. Young said.

One key point of uncertainty is debt-servicing costs. As the government’s debt load soared during the pandemic – to $1.16-trillion in the 2021-22 fiscal year from around $721-billion in 2019-20 – debt service charges remained low, thanks to ultra-low interest rates held down by the Bank of Canada.

Now rates are expected to rise rapidly, which will increase debt-servicing costs as the government rolls over its maturing bonds and issues new debt. The budget argues that debt-servicing costs will remain manageable, increasing to $42.9-billion by 2026-27 (1.4 per cent of GDP) from $26.9-billion for 2022-23 (around 1 per cent of GDP).

Should rates rise faster and higher, however, that could add pressure to government finances, said Randall Bartlett, senior director of Canadian economics at Desjardins.

“The expectation is not just short rates, but long rates are going to start rising, and in a meaningful way that we have not seen really since the Great Financial Crisis,” he said.

“And if that’s the case, that is really where the rubber is going to meet the road, in terms of those public debt charges. … Because every 100-basis-point increase in interest rates has as much impact on the deficit as a 1-per-cent drop in GDP, so it’s quite substantial.”

Federal budget 2022: What it means for you

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