With the global economy at a tipping point, and by extension Canada’s open economy, the September 4th elections in Quebec will be important to both domestic and global investors. The size of future deficits is not really at stake: all major parties are firmly committed to balancing the provincial budget. Rather, the importance of this election stems from the structural changes in the global economy and Canada’s bond market since the previous election in 2008.
In the aftermath of the financial crisis, Canada has benefitted from global capital flows. International investors cautious of U.S. and European markets have perceived Canada as a relatively “safe harbour.” Indeed, according to Statistics Canada, international investors were net buyers of some C$265 billion in Canadian bonds from January 2009 to May 2012. It is not so much that Canada has been an outstanding investment opportunity as that it is among the “cleanest dirty shirt” sovereigns (stained, that is, but not as badly as the rest).
These international capital flows have helped reduce the yields charged to Canadian federal and provincial governments. This is the good news. The bad news is that these international flows tend to be “hot” money. They reflect the decisions of opportunistic investors who can easily leave a country as quickly as they enter it.
This risk is consistent with PIMCO’s view that we are living in a bimodal world (see Figure 1 below). Whereas our baseline forecast of “muddle through” weak global growth may be the expected outcome, it is highly likely that we enter either a virtuous cycle of economic recovery or a vicious cycle of economic decline. One of the main issues facing the global economy is the potential for a breakup of the eurozone. While the situation is complex, the basic problem is that the eurozone is a monetary union but not a fiscal union. This has created stresses that have rippled through Europe’s economies, banking industries and bond markets.
Quebec isn’t Italy, but…
Given this backdrop, Quebec politicians have to be very careful about how they campaign on the sovereignty issue. The election will play out against a backdrop of:
- A global focus on monetary unions without fiscal unions. The lesson from Europe is that this does not work.
- Slowing U.S. and global growth.
- High levels of foreign ownership of Canadian debt (federal and provincial).
- Elevated market volatility as investors struggle with tipping points. Short-term liquidity issues can turn into long-term solvency issues.
There are striking similarities between conditions in Quebec and those that prevailed in Italy prior to the recent spike in its government bond yields. Both regions have long histories of relatively high overall debt-to-GDP but have kept this ratio stable due to primary budget balances (see Figure 2 below). Yet Quebec has avoided Italy’s predicament because it is part of a fiscal and monetary union within Canada, while Italy is in a monetary union that lacks a fiscal union.
As the European debt crisis has evolved, international investors have fled the peripheral countries of Europe (including Italy), causing interest rates in many nations to rise substantially. Italy has tipped from the virtuous cycle of balanced budgets and stable debt-dynamics to the vicious cycle of austerity, low growth and higher yields. What started as a liquidity issue has morphed into a solvency issue as it is highly unlikely that Italy’s economy can support high bond yields over the long term. The key to Italy’s long-term viability within the eurozone is to get nominal GDP growth at or above nominal interest rates. With Italian 10-year bonds trading at nominal rates of about 6%, it does not seem likely that Italy can grow nominal GDP at that this rate. Thus, nominal rates need to fall, which is likely to mean less sovereignty and more fiscal union (see Figure 3 below).
Currently, Quebec is fortunate to have relatively stable debt dynamics. As Figure 4 shows, Quebec’s nominal bond yields are lower than its nominal GDP growth (2011 nominal GDP growth is a PIMCO estimate). Despite a relatively high debt load, planned fiscal consolidation, and the real potential for slower economic growth (mainly due to downside risks from the external environment), investors are currently requiring only a modest risk premium to assume Quebec’s credit risk. In our view, a main reason for low provincial yields is market expectations that the federal government would likely do more counter-cyclical fiscal expansion should Canada face another external shock. Provincial balance sheets are stretched, but the strong federal balance sheet could lend support.
Toward a more perfect union
If Quebec politicians are not careful in this upcoming election, they could call into question the fiscal union that underlies the market’s expectation of potential federal support. The recent Italian experience should be a cautionary warning to Quebec politicians: Policies and rhetoric that undermine international investors’ confidence can quickly lead to higher bond yields, starting the vicious cycle of austerity and lower growth that could lead to fundamental questions of solvency.
To date, provincial and federal policy makers in Canada have generally been very responsible since the crisis started in 2008, allowing Canada to benefit from international capital flows. We hope the winning party in the Quebec election continues the trend. So far, Canada has not been associated with the sovereign debt crisis – and it would be nice to keep it this way.
From time to time, markets “throw the baby out with the bathwater” with a guilt-by-association mentality. This is the risk in this Quebec election. There are no perfect fiscal, political and monetary unions in the world. The preamble to the U.S. constitution admits this by saying “… in order to form a MORE perfect union ….” We hope that Quebec’s leaders will be responsible in their approach to make Canada’s union more perfect. This election occurs in a delicate environment that Quebec’s politicians need to handle with care.