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Canada's Greece? Ontario better get its act together

There's a Paris in Ontario, and a London, and there was even a Berlin until the First World War. Unfortunately, there is also an Athens.

That's a poor omen for a province that risks becoming the Greece of Canada within a decade or two unless the provincial government can come up with and stick to a credible plan to reduce Ontario's deficit.

While Ontario is unlikely to face the same level of stress as Greece, the flashpoints will be the same unless the province changes course. They are: trouble with the bond market, where the province borrows almost half as much as the federal government in some years; faceoffs with public servants over wage and benefit cuts; and fury from citizens facing big austerity measures and new fees.

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The last two will be bad enough now should the government do what needs to be done, but later they are sure to be worse, especially if interest rates jump faster than the government's optimistic forecast.

That's why the province's budget, expected later this month, has to address how to shrink a budget gap that is far larger than any other province's. That requires plans that address not just current realities, when the economy is in rough shape and a deficit seems inevitable, but to deal with what many economists - including former central bank Governor David Dodge - suggest is a significant "structural" deficit that will persist and grow even when the economy fully rebounds.

Mr. Dodge told a business audience in Toronto last week that Ontario's spending is outpacing revenue growth so quickly that the result will be a structural deficit equivalent to 3.5 per cent of the province's economic output by 2020, even in good economic times. By comparison, Greece's structural deficit currently stands at about 5.8 per cent, according to David Rosenberg, chief economist at Gluskin Sheff, who put it kindly when he referred to Ontario's finances as "dilapidated."

Provincial deficits like Ontario's are likely to be "very much more difficult" to eradicate than the federal budget gap, Mr. Dodge opined in a recent talk in Toronto, because provinces are the front line for soaring health care spending. Solutions are likely to require higher taxes and user fees.

Moody's Investors Service has clearly signalled what it (and by extension) the bond market is looking for from provinces. "Failure to communicate and implement clear, realistic and effective fiscal consolidation plans would exert negative rating pressure," Moody's said in a recent report.

Moody's didn't point to any provinces in particular, but Ontario, with the biggest budget gap, is clearly in the spotlight for investors. At 4.4 per cent of gross domestic product, the province's forecast deficit in the current fiscal year is far wider than any other province's.

One-time asset sales such as any attempt to sell a chunk of provincial crown corporations aren't enough, nor are budgets that ignore the need for higher taxes and spending cuts.

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From provinces, "we're not looking for one-time measures that would provide a one-time infusion of cash that couldn't be sustained over time," said Alex Bellefleur, a Moody's analyst who covers provinces. Also, "we don't want rosy expectations of what economic growth will be and provinces saying that revenue growth will solve their fiscal problems, because we don't believe it will."

Already, some of the same dynamics that are testing the strength of the European Union because of the Greek situation are at play in Canada, albeit to a smaller degree.

In Germany, the strongest EU country, the idea of sending money to Greece to bail out a country with more generous national retirement benefits is galling taxpayers.

Here, energy-rich and debt-free Alberta is grumpy that it funds "have-not" provinces that it views as less fiscally responsible. (Saskatchewan is newly emerged from the ranks of the "have-nots" thanks to its mineral wealth, and so is more magnanimous, but who knows how long that will last.) The parallels to the European Union also stretch to monetary policy, with central banks in both having to encompass the divergent requirements of different areas.

As oil pushes past $82 (U.S.) a barrel, the prospects for Western Canada brighten. At the same time, higher oil means the Canadian dollar is yet again surging, the last thing that factories in Ontario that export to the U.S. want to see.

As the economy nationwide heats up, the Bank of Canada has started to signal interest rates will rise in the second half of the year. That's likely to exacerbate the issue by further bolstering the currency.

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So far, the bond market is relatively sanguine about Ontario, and the situation is unlikely to ever get as bad as Greece because investors know the federal government will be there to bail out the province if need be. Still, bond markets are pricing in more risk.

Investors now demand 0.70 percentage points more yield on a nine-year Ontario bond than on a Government of Canada bond of similar maturity, according to Bloomberg figures. Three years ago, that difference was 0.25 points.

The biggest risk for the government is that investors start to lose confidence and demand much higher rates to buy Ontario bonds. As of last fall's fiscal update, the Ontario government was paying an average 4.85 per cent interest rate on its debt, lower than any time in the past two decades.

Investor Education: Bonds

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Most everybody agrees that rates are going higher. Ontario's forecasts have been for a slow and steady increase in rates that keeps the pressure off refinancing. However, borrowing costs have a nasty habit of jumping in a hurry.

"What we're saying is that in the past sometimes these increases in rates have been sharp and steep and that represents a risk for government finances," said Mr. Bellefleur of Moody's.

The stakes are high: For every 1 per cent increase in the forecast rate, Ontario would pay an additional $520-million in interest costs, according to Finance Minister Dwight Duncan. For a government expecting revenue of $90-billion in the current fiscal year, that's a big chunk of change.

That risk is why the government of Ontario can't delay. Inaction will spook investors, leading to higher rates and an even more politically unpalatable outcome. Mr. Dodge, speaking from his experience in the federal Finance Department during the deficit-fighting years of the 1990s, knows full well that just paying interest bills gets little respect from voters.

"Nothing undermines a government's credibility with the taxpayers as the perception that they are getting only 60 or 70 cents on every tax dollar in terms of services."

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