Blogs & Comment

How higher interest rates could make Ontario’s debt problems even worse

The province’s debt load has ballooned during a time of historically low interest rates. As rates begin to rise again, the cost of that debt will too

Ontario Premier Kathleen Wynne

Ontario Premier Kathleen Wynne. (Marta Iwanek/CP)

Ontario’s debt currently stands at a whopping $300 billion. It has doubled over the past decade and is projected to reach $350 billion by 2020, according to the province’s own Financial Accountability Officer.

Interest on the debt, at 9% of annual budget spending, is now nearly half of what the province spends on each year on education and more than one-fifth of what’s spent on healthcare. Just as alarming is that interest on this debt is increasing at an annual rate of 5%, outpacing spending increases on every other budget item.

Expressed in dollars, it is costing Ontario roughly $12 billion a year to cover interest payments. That’s money not being spent on expanding healthcare for an aging population, or bolstering education for tomorrow’s workforce. All Ontarians should be gravely concerned. And it could easily get much worse.

After eight consecutive years of deficits the goal of a balanced budget remains elusive. One-time events, such as the partial sale of Hydro One, have created the impression that balanced budgets are within reach. There is also a presumption that Ontario’s predominantly service-based economy is on stable ground. Yet there is credible concern that asset bubbles are surfacing in financial and real estate markets. Should these bubbles pop the financial impact to Ontario’s revenues will be considerable. Such a scenario would drive the deficit higher, and along with it the size of the debt – and interest on that debt.

This is happening at a time when the Ontario government has committed to spending $160 billion over 12 years to improve Ontario infrastructure. Improving crumbling infrastructure and creating new jobs is a worthy endeavour, but it will add significantly to Ontario’s debt load, whether or not the government goes it alone on projects or partners with the private sector. It’s a big reason why the Financial Accountability Officer believes Ontario’s debt will increase to $350 billion by 2020. And the $160-billion figure assumes projects will come in on time and on budget, which has not historically been the experience in Ontario.

Another shaky assumption is that interest rates will remain at rock bottom. Ontario’s rates are heavily influenced by U.S. rates, which have just begun to increase after years at historic lows. Ontario has benefitted from such low rates—the average rate on provincial debt is now about 3.5%. Yet with interest rates in the U.S. starting to gradually rise, Ontario rates will also trend higher. This suggests a return to the normalized rate of 5.5%, which would result in Ontario’s annual interest costs moving from $12 billion to $13 billion and climbing to $17 billion once all debt is refinanced.

And let’s not forget that, because of the size of Ontario’s debt, it has had to raise money outside of Canada, in order to to tap into larger pools of capital. Ontario currently has a quarter of its debt issued in foreign currency, and the risk is that the Canadian dollar declines against the U.S. dollar and Euro. The degree of a decline can potentially add billions to debt levels. Ontario may be hedging the currency risk, but there’s little clarity on how effective it has been.

The big picture this all paints is not pretty. How can the government balance the budget, assure spending increases for healthcare and education, and at the same time face the headwinds of higher and higher interest rates on its debt?

Simply put, balancing the budget through spending cuts alone will not work. Wave upon wave of higher interest rate costs will crash any attempt to build a balanced budget. This will set off a vicious cycle of higher deficits that lead to higher debt, which in turn will mean higher interest costs and less funding available for healthcare, education and other provincial services. Ministries across the board will be constantly pressured to tighten their belts.

So what’s the path forward? There are several courses of action to pursue.

1. Balance the budget through spending cuts

Certainly, the bleeding needs to be stopped, and making the necessary spending cuts will be painful. Paul Martin, when he was federal finance minister, did an exceptional job of killing the vicious cycle during the 1990s. It was unpopular, and for him mentally excruciating, yet necessary to preserve Canadians’ standard of living over the long term. His involvement would be highly valued. As would other key players, including former TD Bank chief economist Don Drummond (author of a detailed report outlining cost-cutting opportunities in Ontario) and former parliamentary budget officer Kevin Page, who has spent decades uncovering wasteful spending in the public service.

2. Cut financial and regulatory costs for business

Small and medium-size businesses drive job growth, innovation and tax revenues. To support these businesses Ontario must cut financial costs, including industrial electricity rates (the highest in North America), mandatory wage minimums, pension obligations, excessive WSIB costs and taxes on capital purchases. Non-financial costs must also be reduced. These include redundant and inefficient paperwork and regulatory compliance such as the HST refund process. They should be replaced with streamlined and automated systems. Furthermore, turnarounds between regulatory applications and approvals need to be expedited to reflect the fact business is on a 24-7 clock.

3. Make strategic improvements in trade

Small percentage increases in net exports have a material impact on Ontario’s budget. Fortunately, there are a number of strategic opportunities to pursue. For example, Ontario runs a very large trade deficit with China and a smaller one, though still sizeable, with Mexico. The province needs to persuade China and Mexico to increase their import of Ontario goods and services.

How can it do this? With respect to China it can pursue the same path that other parts of Europe and the U.S. are doing: engaging in deeper trade relations with the Association of Southeast Asian Nations (ASEAN). The ASEAN countries make an attractive alternative to China, given they have higher growth rates, less debt and younger demographics. Ontario can utilize these markets to source the same low-cost imports it does from China while opening their markets to Ontario’s value-added goods and services that these countries require in order to modernize. This should influence China to improve the trade balance with Ontario so that it may maintain the strong links to Ontario that it has aggressively pursued in recent years.

Similarly with Mexico, Ontario could pursue a more engaged and focused relationship with with the Mercosur trading bloc (Argentina, Brazil, Paraguay and Uruguay). This would allow Ontario to counter the growing trade balance with Mexico by opening other opportunities in Latin America and pressure Mexico to improve its trade balance with Canada.

Ontario continues to see the same Chinese and Mexican officials coming through the province. Vice versa our politicians are constantly invited to visit those countries. Why? Because China is extremely aggressive in the courting of Ontario politicians and because Mexico offers a comfortable proximity. Ontario politicians and civil servants need to step up their efforts and expand their focus beyond these usual suspects.

Finally, services account for about 75% of Ontario’s GDP, and the majority of these services are in knowledge sectors such as financial services, insurance, healthcare, information technology and cleantech. The global markets for these services are in the hundreds of billions of dollars and have attractive growth rates. There is a major untapped opportunity for Ontario to facilitate service exports to developing countries seeking to modernize their economies.

The path forward may be complex but the challenge Ontario faces today is clear: It can no longer ignore the reality that the conditions for much greater financial pain are beginning to emerge and poised to take hold over the next several years. The province needs to get ahead of the threat now to maintain a reasonable standard of living for all Ontarians. Spending cuts alone won’t slay the province’s growing debt monster.

Jarrett Hasson is a portfolio manager who has worked in the Canadian investment industry for the past 15 years. In 2013, he was part of a two-person team that won the Lipper Award for top alternative fund in Canada for three-year performance.