In the fall of 2020, Finance Minister Chrystia Freeland gave a speech outlining Ottawa’s approach to debt management during the COVID-19 pandemic.
Yes, the federal government was borrowing unprecedented sums of money to fund pandemic support programs. But the risk to the country’s fiscal health remained limited, Ms. Freeland argued in her first major address as minister.
With interest rates at rock bottom, the cost of servicing the mounting pile of debt was at a historic low. Looking forward, “deflation and subpar growth” seemed to pose a greater risk than the “twin threats of inflation and spiralling debt,” she told the virtual audience.
Three years on, this argument has been flipped on its head. Instead of remaining quiescent, inflation surged in 2021 and 2022, prompting the Bank of Canada to raise interest rates at the fastest pace in a generation.
Yields on Government of Canada bonds are now at the highest level since 2007, making it more expensive for the government to borrow new money and refinance outstanding debt. A growing number of economists – including Bank of Canada Governor Tiff Macklem – are speculating that the global economy is entering a period of structurally higher borrowing costs compared with the period before the pandemic.
This macroeconomic shift has left federal and provincial policy makers in a tricky spot. Having greatly expanded their debt loads during the pandemic, governments face higher interest costs as that debt rolls over.
The federal government expects to spend $43.9-billion on interest payments this fiscal year, up from $24.5-billion two years ago, according to its 2023-24 budget. The actual number could well come in higher, as bond yields have risen further since the budget was published in March.
We’re still a long way from the fiscal crisis of the early 1990s, when the federal government was spending more than 30 cents of every dollar it collected on interest payments. The budget projects an interest expense-to-revenue ratio of around 9 per cent in the coming years. That’s up from an average of 7 per cent in the five years before the pandemic, but still low by historical standards.
Nonetheless, the step-up in debt servicing costs has real implications for fiscal flexibility. Billions of additional dollars spent on interest payments means less money for other government priorities, especially if the economy slows and government revenues decline, as is widely expected. Higher interest rates also make it harder to justify borrowing new money for public-sector investments – a tough pill to swallow for a federal government with a penchant for deficits.
In recent decades, governments have benefited from benign fiscal arithmetic. Because economic growth rates exceeded interest rates paid on debt, interest costs remained manageable even as the overall debt load ballooned.
Today, this math is less forgiving. There’s a good chance that interest rates will exceed economic growth rates in the short to medium term, according to former Bank of Canada governor David Dodge. And that state of affairs has both economic and political consequences.
“As long as governments appear to be delivering services commensurate with what they’re taking from people in terms of taxation, then basically things are okay,” Mr. Dodge, who also served as deputy finance minister during the deficit-cutting 1990s, said in an interview.
“The one thing that people don’t give governments any credit for is servicing a past debt. So as that zero-credit component eats up more and more of the revenue stream you’re taking in, the government becomes less politically sustainable over time.”
The surge in interest rates caught both Ottawa and Bay Street by surprise.
In early 2022, the Department of Finance polled a group of private-sector economists to come up with a forecast for the spring budget. The economists expected the yield on three-month treasury bills to average 0.8 per cent that year, and the yield on 10-year Government of Canada bonds to average 2 per cent.
The Bank of Canada had other ideas. Caught off guard by inflation, the central bank began raising rates at the fastest pace in decades, lifting the overnight rate and pushing up interest rates across the yield curve. By the end of 2022, the yield on three-month T-bills was above 4 per cent and the yield on 10-year bonds had reached 3.5 per cent – levels not seen since before the 2008-09 global financial crisis.
This lightning-fast adjustment took a chunk out of the federal budget. The government had projected roughly $27-billion in debt charges for 2022-23; the actual number came in around $35-billion. The 2023-24 budget, released in March, sees annual debt charges rising to $50-billion by 2027-28.
Bond yields have continued pressing higher in recent months, spurred on by two additional rate hikes from the Bank of Canada this summer, and a growing sense among market participants that Mr. Macklem and his colleagues at other major central banks intend to keep interest rates “higher for longer” to get control of stubborn inflation.
That suggests public debt costs could once again exceed the budget projection. The Department of Finance estimates a one percentage point rise in interest rates increases debt charges by $3.8-billion in the first year, rising to $10.3-billion by Year 5. The actual impact on the budget is somewhat offset by a decline in the government’s pension liabilities, which fall when interest rates rise, and an increase in revenues from interest-bearing assets.
Public debt charges in June were $1.3-billion higher than the same month a year ago, an increase of 55 per cent, according to the latest Fiscal Monitor, published by the Department of Finance.
“The big question right now is, over the medium term, where does that neutral interest rate lie or where does that long-term 10-year rate lie?” said Rebekah Young, Bank of Nova Scotia’s head of inclusion and resilience economics. The neutral rate is a theoretical level for the Bank of Canada’s policy rate that neither stimulates nor holds back the economy.
So far, there are few signs that higher debt costs are constraining fiscal decision making, Ms. Young said. After all, interest payments remain small relative to the size of the economy, clocking in at 1.6 per cent of gross domestic product this year, up from around 1 per cent before the pandemic, but well below the 4 per cent to 6 per cent range seen in the 1980s and 1990s.
That said, if the actual dollar amount being gobbled up by interest payments gets too big, it could have “political economy considerations,” she said.
“Even if it’s not a runaway trajectory of debt servicing, either as a share of GDP or as a share of revenues, you can start seeing it as the cost of a dental program, or a whole new program,” Ms. Young said.
“From an economic point of view, that shouldn’t influence things. But public perception can tip when they start to see these bigger and bigger numbers and the opportunity cost that comes with that.”
Credit rating agencies, which help determine how much governments pay to access financial markets, remain fairly upbeat about the situation.
Fitch Ratings Inc. downgraded the federal government’s debt from AAA to AA+ in the summer of 2020 in response to the swelling deficit. But the other two big ratings agencies, S&P Global Ratings and Moody’s Investors Service, have retained their top credit ratings for Canada. Most provincial ratings remain intact, with a few exceptions, such as British Columbia, which S&P downgraded earlier this year.
Bhavini Patel, a director and lead analyst with S&P, pointed to several factors that are moderating the impact of rising interest rates.
Economic growth has been surprisingly strong over the past two years, lowering debt-to-GDP ratios for governments and filling coffers with tax revenue. This has allowed federal and provincial governments to run smaller deficits than anticipated and issue less new debt, Ms. Patel said.
There’s also a mechanical issue: Only a portion of government debt matures and needs to be refinanced each year. That slows the pass-through of higher interest rates to higher interest payments. The average term to maturity (ATM) for federal debt is around 7½ years, while the ATM on provincial debt ranges from 10 to 12 years.
“We’re only seeing about one-10th of the total portfolio roll over in any given year,” Ms. Patel said of the provinces. “So the impact of higher debt [servicing costs] is more of a medium-term risk than one that we’re seeing in the short term.”
Michael Yake, Canada country manager for Moody’s, echoed this sentiment about stronger-than-expected growth and higher tax receipts.
“The starting point is good,” Mr. Yake said. “Now it really just depends on how long this current [interest rate] environment lasts. The provinces and Canada can withstand a few years without material credit pressure. But if they do start rolling over, and the majority of their debt starts having these higher interest rates, then we’re going to see that impact.”
Governments did reduce some of this rollover risk by issuing more long-term bonds during the pandemic.
In the fall of 2020, the federal government began issuing far more 10-year and 30-year bonds. This was partly to lock in low interest rates, and partly to lengthen out the ATM of federal debt, which had fallen from 7½ years to five years early in the pandemic, as the government funded its emergency spending with short-term T-bills.
University of British Columbia economics professor Kevin Milligan worked as a special adviser to the federal government in 2020 and 2021. He said there was considerable debate at the time about whether more should be done to lock in ultralow interest rates.
“There was certainly a view professed by some: Shove those long bonds out until we see [the market] choke on it. Others were more cautious,” Prof. Milligan said.
At the peak in fiscal 2021-22, 45 per cent of new bonds issued by the federal government had terms longer than 10 years, up from a pre-pandemic average of around 20 per cent. Prof. Milligan still isn’t sure this went far enough.
“When the interest rate is low, you should be locking in an awful lot of long-run term interest rates until you see the whites of their eyes. And it’s not clear to me that we saw the whites of their eyes,” he said.
The Department of Finance ended its bias toward long-term bonds earlier this year, moving back to a more balanced approach to issuing debt. It also began tweaking around the edges of its debt management strategy, in an apparent attempt to eke out savings. It stopped issuing real return bonds, which cost the government more as inflation increases. And it’s currently contemplating rolling the Canada Mortgage Bond program into general government borrowing.
To hear the federal government talk, debt management remains on an even keel. The 2023-24 budget projects the debt-to-GDP ratio will tick up slightly next year straining the government’s promise to keep the ratio on a downward slope over the medium term – its “fiscal anchor.” But Ms. Freeland maintains the fiscal anchor is sound and the current path is sustainable.
“As recent data shows, demand for Aaa Canadian bonds is high – including against U.S. Treasuries. This is positive for Canada,” Finance Department spokesperson Jessica Eritou said in an e-mail, responding to questions about how the government’s debt-management strategy has changed with higher interest rates.
But the rapid rise in debt costs should give Ms. Freeland and her team pause, according to Mr. Dodge. In a paper published earlier this year, the former central banker warned that governments run into trouble when they start spending more than 10 per cent of their revenue on interest payments. We’re not there yet, Mr. Dodge wrote. But some combination of slower economic growth, deficit spending and persistently high interest rates could easily push the ratio above that threshold in the coming years.
Robert Asselin, senior vice-president of policy at the Business Council of Canada, who co-wrote the paper with Mr. Dodge, said that a rising debt service ratio doesn’t mean debts are about to spiral out of control, as they did in the 1990s.
But it could mean that policy makers will be forced to make increasingly hard decisions about cutting spending or increasing taxes.
“It’s not a question that tomorrow Canada won’t be able to sell its bonds or market. It’s more a question of are we putting ourselves in a bad situation where we’re eventually going to have to make really difficult choices,” he said.