Bank of Canada rate hikes could add strain on Ottawa’s debt servicing

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When Finance Minister Chrystia Freeland delivered the 2022 federal budget in April, the Bank of Canada had only just embarked on its aggressive hiking cycle and interest rates sat at a paltry 0.5 per cent. When she rises in the House of Commons Nov. 3 to unveil the government’s fiscal update, she’ll be facing a new financial reality.

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In the seven months in between, the central bank’s policy rate has soared to 3.75 per cent and similar moves around the world are forcing governments to seriously consider the rising cost of servicing their debts and the burden of new deficits.

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Economists argue that not only is the central bank’s mission to stomp out decades-high inflation putting upward pressure on public borrowing costs, it also risks triggering a recession that could put an even greater strain on government finances.

In a recent note, Desjardins’ senior director of Canadian economics Randall Bartlett wrote that while Ottawa’s finances have been improving since the depths of the pandemic — fuelled largely by higher, inflation-driven revenues — the current risk outlook leans more toward larger deficits.

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“I think (rising debt costs and recession risks) go hand-in-hand really, to be honest,” Bartlett said. “It’s really just a function of an economic downturn — revenue growth slows, expense growth rises as a result of that. Then you layer on the gradual effects of higher inflation feeding into higher spending, plus higher interest rates which are leading to the economic downturn. So, it’s a bit of a perfect storm for a weaker fiscal forecast.”

In Bartlett’s Oct. 28 fiscal update preview, he noted that the Government of Canada’s borrowing costs are set to rise sharply with the central bank’s series of outsized rate increases, but will still remain lower in a broader historical context.

However, the Desjardins team also noted that what makes Canada’s federal government stand out is that its debt obligations tend to have shorter-term durations compared to other advanced economies. Bartlett noted that this hadn’t changed much during the pandemic.

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“As a result, the Government of Canada will feel the impact of higher interest rates more quickly that other jurisdictions that took advantage of ultra-low-for-long borrowing rates,” Bartlett wrote. “Consequently, we are of the view that the federal government will see public debt charges increase more quickly than anticipated by the (Parliamentary Budget Officer) as the effective interest rate on the federal debt ratchets up.”

Douglas Porter, chief economist at BMO Capital Markets, said it has been a while since rising interest costs have been a focus in government finances.

“This is really the first time in, I would say decades, that interest costs have really been a factor in government finance,” Porter said. “Of course, they were the dominant factor through much of the ’80s and ’90s, but they’ve really faded as you know as a key driver of government finances.”

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Porter added that since the pandemic, when the government took on huge amounts of new debt, the risk posed by higher borrowing costs has risen dramatically. While the economy has grown significantly since the mid-1990s and current debt service costs are still relatively manageable, he noted that on an absolute basis recent monthly debt charges of $3.6 billion were not far from that era’s all-time highs.

Derek Holt, head of capital market economics at Scotiabank, argued that rising rates will have a significant impact on the federal government’s finances and could shake up the government’s projections for interest expenses. Holt noted that during the spring budget earlier this year, the government had projected public debt charges of $25 billion in fiscal 2021/22 to increase in a neat, linear upward trajectory to $43 billion in the fifth outer year of their projection.

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“Now, however, I think we have to go back to the drawing board because the assumptions upon which even that increase in public debt charges are based are looking pretty optimistic now,” Holt said. “Well, they’re just flat-out wrong.”

They’re just flat-out wrong

Derek Holt

Holt also pointed to the growth in T-bill yields, which he said the government also misjudged earlier in the year as he noted the initial eight per cent average yield the government assumed on the 90-day T-bill was now at least 100 basis points higher for the year.

“So, what it does is essentially brings forward that nice, neat, steady upward trajectory, probably within the next year or two as we go into 2023,” Holt said. “So, it’s a material, additional form of crowding out what they could otherwise be spending on other initiatives.”

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Holt does not expect a return to austerity with this week’s fiscal update, but is hoping to see discretionary spending reined in. The government could also be stuck between a rock and a hard place as far as its measures go to assuage the New Democratic Party with promises of a dental care package and to avoid market scrutiny with more spending.

“You’re either going up against the pacts between the Liberals and the NDP if you back off on some of the budget spending amounts, or you’re going to get markets breathing down your neck if you signal that you’re backing off on those fiscal anchors given the sensitivities now,” Holt said.

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While austerity may not be the order of the day, CIBC deputy chief economist Benjamin Tal is among those who does not expecting a swath of new spending measures that would make the Bank of Canada’s fight against inflation that much more difficult.

“I think the update will be very light on new spending, acknowledging that the improvements on (financial) position is one-off and that higher rates will limit ability to spend,” Tal said. “As well, they will be very careful not to sabotage monetary policy. That is not to go the opposite direction (than the Bank of Canada).”

The recent drama in the United Kingdom provided a glimpse of what can happen when there is a stark mismatch between fiscal and monetary policy. When then-prime minister Liz Truss included a corporate tax freeze as part of her budget plan without explaining how it would be funded, yields on government bonds soared, sparking a bond market crisis. She was eventually forced to resign.

It’s a lesson from across the pond that Porter believes will be heeded by the Department of Finance.

“In fairness, I do believe the finance department got the message loud and clear … that, if anything, there was too much stimulus in the economy in the last couple of years and it made no sense to further fuel the economy when demand was just not the issue,” Porter said.

• Email: shughes@postmedia.com | Twitter: StephHughes95