By Jeremy M. Kronick and Thorsten Koeppl
Since the COVID-19 crisis began, yield spreads for provincial 10-year bonds over equivalent federal debt have increased by about 100 basis points across all provinces. Some provinces — Newfoundland, for example — are in even worse shape. To ease funding pressures on the governments that are on the front line in health care and social assistance we need a two-pronged approach in which the Bank of Canada addresses disruption in the debt markets, and an overhauled federal fiscal backstop helps provinces still in need.
The Bank of Canada is already providing liquidity to the provinces by purchasing short-term provincial debt, thus helping alleviate rollover concerns. It has also embarked on a large-scale asset purchase program — better known as quantitative easing (QE) — in which it purchases Government of Canada debt across all maturities. On Wednesday, it expanded QE to include longer-term provincial debt, as well. The new program is capped at $50 billion and will last 12 months, with the option to expand the parameters if conditions warrant. Debt from all provinces is eligible, with maturities up to and including 10 years. These new purchases will reduce provincial borrowing costs in a way that avoids a direct federal intervention that would blur the principles of fiscal federalism.
Wednesday’s announcement said further specifics would be filled in by month’s end. What might these additional details look like?
Extended lending cannot be seen to support one province over another. That would put the Bank in the difficult position of deciding which credit risks to take on, which is not one of its functions and might ultimately jeopardize its independence. Moreover, QE will significantly expand the Bank’s balance sheet, which could lead to a spike in future inflation. Any large-scale asset purchases must therefore be managed appropriately and not become excessive.
That leads us to believe a simple rules-based approach is in order. The increase in yield spreads has been fairly uniform across provinces, which suggests the disruption is market-wide. It also presents a target that the Bank’s interventions can aim for, namely a pullback in the average increase in spreads, across provinces, for all maturities. It can achieve this by buying debt according to the share of provincial to Canadian GDP, ensuring equity across provinces. Because the Bank’s mere presence may calm provincial funding markets, thereby lowering spreads, the interventions can start small, which $50 billion likely is.
Some provinces may need more, however, as they stare at default, their already weak fiscal position aggravated by the pandemic. So a federal backstop is needed. But Ottawa already has one in the Fiscal Stabilization Program (FSP), which is designed for exactly the current scenario, in which a large decline in a province’s revenues calls for additional federal transfers.
Unfortunately, the program is far too small. Provinces can only get up to $60 a person, an amount unchanged since 1987. Any amount beyond that becomes an interest-free loan, to be paid back over five years. Neither the dollar cap nor the design of the loan portion seems appropriate to us. In Ontario, $60 per person amounts to less than $1 billion. The Ontario government is projecting a deficit for 2020-21 of $20.5 billion. Even adjusting the cap for inflation only slightly more than doubles the assistance. That leaves the possibility of a loan. But if provinces are left in the same dire fiscal situation once the interest-free period ends, a loan may not be much help.
Another option involves “consols” that a province would issue to the federal government. Consols are bonds that a province can repay at any time and that — until repaid — bear an interest payment in perpetuity. The money they raised could effectively bail out a province but would cost it something so long as interest rates were set appropriately. For example, one could use the average interest rate on a five or 10-year bond over a fixed period, say five years prior to the COVID-19 episode. A province could regain full fiscal independence by redeeming the debt in the future. In effect, it would pay for its bailout but spread the cost out over a period of its own choosing.
Provinces are starting the current crisis from a worse fiscal position than in 2008 when, arguably, they bore the heaviest fiscal impact. Unfortunately, they did not use the subsequent recovery to put their books in order. We should not reward the poor decisions of the past but we do need to recognize the uniqueness of the COVID-19 economic shock. Having the Bank of Canada act first was best. If some provinces need further support, a redesigned Fiscal Stabilization Program will serve. In fact, crisis or no crisis, it’s time to revamp the federal backstop.
Thorsten Koeppl is a professor of economics at Queen’s University and scholar in financial services and monetary policy at the C.D. Howe Institute, where Jeremy M. Kronick is associate director, research.