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fixed income

The fixed-income world is pretty comfortable with Canada's government debt situation. Maybe more comfortable than it should be.

The Macdonald-Laurier Institute, an up-and-coming policy think tank based in Ottawa, released a study this week warning that several Canadian provinces are on worrisome debt trajectories that could, unless they change course, lead to debt crises or even defaults. What's more, the report said, the bond market hasn't grasped the ramifications of this risk.

"Canadians may be too complacent if they think that the debt crisis wracking Europe cannot happen here," wrote Marc Joffe, the former Moody's credit analyst who authored the report. "In the medium to long term, public finances in several provinces are unsustainable, raising the spectre of debt crises, damaged credit ratings, and federal bailouts if corrective steps are not taken."

This is a bit of a smack in the face for those of us who had believed Canada's government debt levels were the envy of the industrialized world.

Yes, Canada's net government debt as a percentage of gross domestic product is a modest 36 per cent, according to the International Monetary Fund – by far the lowest in the G7. (Germany is next-best at 54 per cent; Italy is at 102 per cent and Japan, 135 per cent.)

But some provinces are running considerably higher numbers. Quebec's net provincial debt is north of 50 per cent of its GDP, while Ontario's is above 35 per cent – and that doesn't include those provinces' share of the federal debt load. Still, relatively speaking, those are far from dangerous numbers. Mr. Joffe calculated the risk is "essentially zero" that any Canadian province could default in the next five to 10 years. But based on expected demographic, interest-rate and spending trends, he calculated that risks of default climb into some pretty frightening territory in the longer term.

"Due to population aging, the provincial models forecast lower labour force participation, less economic growth and higher health spending in later years," the report said. "Depending on how quickly interest rates revert to their post-World War II means, provinces are at risk of encountering solvency crises over the next 10 to 30 years if fiscal policies do not change." Mr. Joffe projected that if the provinces keep going the way they are, most will have a 50-per-cent probability of default 30 years from now. Ontario's default risk will be 79 per cent; Alberta's, 84 per cent. That's approaching Greece territory.

Now, this is just one study's mathematical projections, based on a series of assumptions and trend lines that may or may not come to pass over several decades. A lot can change in government finance in 30 years. But in the bond market, where investors are buying government debt that doesn't mature for up to 30 years, these risks matter in valuing the debt securities. And by Mr. Joffe's estimates, the market isn't even close to pricing in these risks. Based on long-term risk models, he estimated that provincial 30-year bond spreads over the government of Canada 30-year bond should be in the range of 500 basis points – not the current roughly 100 basis points.

This massive gap represents something of a leap of faith that exists in the bond market when it comes to Canada and its provinces. The risks Mr. Joffe is talking about are based on the provinces being on their own in a debt crisis. The market, on the other hand, has long operated on the assumption that provincial debts are implicitly backstopped by Ottawa. There's nothing in law that says the federal government will rescue a debt-riddled province from default. But there is precedent. Ottawa rescued Alberta from default during the Great Depression, and provided funds to several other provinces to avoid defaults during the same period. For the bond market, apparently, that's been good enough. But since these events don't come up very often, it's hard to judge what kind of appetite Ottawa would have to guarantee provincial debt burdens now – much less 20 or 30 years from now.

Economist Don Drummond suggests Ottawa may need to address the issue, before it becomes the kind of muddled political football it now is in the EU. "Federal fiscal protection may need to extend to a clarification of the conditions under which it will assist a province with its debt," he wrote in the forward to the report. (Mr. Drummond is on Macdonald-Laurier's advisory council.) And Macdonald-Laurier may be the group to nudge this onto Finance Minister Jim Flaherty's agenda. The group's founder and managing director, Brian Lee Crowley, was an economic adviser in the Finance Ministry under Mr. Flaherty from 2006 to 2008. This report doesn't have to take a big leap to get from Mr. Crowley's desk to Mr. Flaherty's ear.