On April 19, the federal government tabled its first budget in more than two years. The budget confirms a deficit for the past year, which reflects the current situation. Several support measures for businesses and workers are extended and reinforced to put an end to COVID-19 and promote economic recovery. Minister of Finance Chrystia Freeland anticipates further deficits as the country emerges from the pandemic.
This newsletter summarizes the highlights of the budget, which contains more than 200 new measures. The summary is followed by our analysis. Since the budget has not yet been adopted by Parliament, the proposed measures could undergo changes.
Unsurprisingly, the pandemic has caused a drop in revenues and an increase in federal government spending, resulting in a deficit of $354 bn or 16% of GDP for 2020-2021. In terms of percentage of GDP, this deficit is the highest since World War II; from 1942 to 1945, Canada’s deficit ranged from 17% to 22%.
The federal government is also anticipating deficits in subsequent years. These are expected to decline gradually from $155 bn (6.4% of GDP) in 2021-2022 to $31 bn in 2025-2026. No target has been set for a return to balanced budgets.
As for revenues, they declined in 2020-2021 (-11.3%) but are expected to exceed 2019-2020 levels in 2021-2022. Starting in 2022-2023, the average annual increase in revenues is projected to be 5.4%.
Expenditures will increase as part of an economic recovery program totalling $100 bn over a three-year period, broken down as follows: $49 bn in 2021-2022, $28 bn in 2022-2023 and $24 bn in 2023-2024.
Despite an increase in the debt, debt servicing costs will be lower in 2020-2021 and 2021-2022 than they were in 2019-2020. However, these costs represent an increasingly large proportion of revenues, and should exceed pre-pandemic levels as of 2023-2024.
Lastly, the federal debt totalled $1,079 bn as at March 31, 2021, a 49.6% increase over the previous year. It is projected to stand at $1,411 bn as at March 31, 2026.
The debt-to-GDP ratio is anticipated to peak at 51.2% in 2021-2022, which is higher than at any point since the early 2000s. Nonetheless, this is lower than the previous peak of 66.6% in 1995-1996. The debt-to-GDP ratio is then expected to decline to 49.2% in 2025-2026.
Source: Research Chair in Taxation and Public Finance at Université de Sherbrooke, Regard CFFP no. 2021-04, author: Luc Godbout, Chair.
The federal budget contains numerous measures which the government claims will enable the country to see its way out of the pandemic. These measures will have an economic impact, notably on growth, the bond yield curve, and long-term inflationary pressures.
The government’s message conveyed in the budget is that the proposed measures are needed to defeat COVID-19 and restart the economy. In the government’s opinion, now is not the time to think about debt and deficits. But is this the right approach for the country?
According to Minister of Finance Chrystia Freeland, it would be foolish not to take advantage of low interest rates by means to boost spending. This is encouraged by the Bank of Canada, which is anchoring rates at close to zero because it is not anticipating any significant increase in inflation for the moment. The emphasis on deficit spending rather than fiscal conservatism represents a shift from previous decades. This change in mindset, which is a positive factor for short-term growth, is happening worldwide.
With this increase in spending, the government is mitigating the decrease in growth caused by the pandemic by stimulating consumption. According to the 2021 budget, this will support the GDP, which is expected to grow by 5.8% in 2021, 4.0% in 2022 and 2.1% in 2023.
Steepening of the bond yield curve
The government expects the deficit to fall back below the country’s nominal growth in 2022-2023. Thus, the debt-to-GDP ratio will peak in 2021-2022 before trending down over subsequent years. According to budget data, thanks to the multiplier effects due to the stronger GDP growth in the short term, debt-to-GDP levels are forecast to be roughly where they would have been without the stimulus measures by 2025.
Canada’s net federal debt is lower than those of the other G7 countries, as shown in Chart 6. Furthermore, the S&P rating agency has already confirmed the country’s AAA rating following its assessment of the budget, while Moody’s reiterated its confidence in that rating back in February. This puts Canada in an enviable position.
Note: The general government definition includes the central, state, and local levels of government, as well as social security funds. For Canada, this includes the federal, provincial/territorial, and local government sectors, as well as the Canada Pension Plan and the Quebec Pension Plan.
Source: IMF, April 2021 Fiscal Monitor; Department of Finance Canada calculations.
Nonetheless, the projected deficits will need to be financed and absorbed by the market. The Bank of Canada, which was buying $4 bn in government bonds per week until April 2021, will now be buying only $3 bn per week, for an annual purchase of $156 bn. If this rate of purchase remains unchanged through 2022, the Bank of Canada would be purchasing the equivalent of 100% of new issuance in 2021 and 260% of new issuance in 2022. The Bank’s purchases are expected to lessen the upward pressure on interest rates caused by the increase in supply.
At the same time, the federal government plans to increase the average term to maturity of the bonds it issues: it will stand at close to nine years in 2021-2022, versus seven years in 2020-2021. Until now, the Bank of Canada has been buying bonds with a 7.5-year term as part of its quantitative easing program, and it has announced that it will not be increasing the term of its purchases to match the government’s new issuance strategy. There will therefore be a mismatch between the Bank’s purchases and the government’s new issuance; this will put some upward pressure on long-term bond yields (while the opposite will occur for short-term rates). The result should be a steepening of the bond yield curve.
Long-term inflationary pressures
Over the longer term, increased reliance on budget deficits supported by artificially low interest rates will have an inflationary impact. Several countries have implemented quantitative easing programs since the 2008 crisis, and although this supported the prices of purchased assets, it has had little impact on the real economy, and thus, on inflation.
In the current context of budget deficits, where money is going into the pockets of households that have a strong propensity to consume, the effect on inflation is expected to be more pronounced. Indeed, the resulting increase in demand for goods and services will put pressure on supply chains and force an increase in input prices. Over time, this effect will prove inflationary because businesses will seek to preserve their profit margins by increasing the cost of consumer goods.
A significant and lasting increase in inflation might take some time to materialize, but current interest rates do not take this situation into account. Nominal bond yields should normally reflect a country’s real GDP and inflation rate. The yield of Government of Canada 30‑year bonds currently stands at 2%. If the annual real GDP growth is 2% over the next 30 years, this means that the market-implied inflation expectation is 0%. Even if inflation merely matched the central bank’s 2% target for the next three decades, the fair value of 30‑year interest rates should therefore be 4%, quite a jump from current levels.
We believe that our portfolios are designed to achieve the best potential performance in light of the three dynamics discussed above. To take advantage of the positive development in the global economy that is primarily driven by the various national economic stimulus programs, we are reducing our allocation in bonds to a minimum and favouring equities within balanced mandates. Furthermore, our bond portfolio is invested in very short bonds (with an average term of two years) and has no exposure to bonds maturing in more than 10 years, while the average maturity of the benchmark is eight years. As the yield curve steepens and inflation pushes long-term yields higher, longer bonds will incur capital losses. Our strategy will help avoid such losses and ensure that capital is preserved.
The information contained herein is provided for informational purposes only, is subject to change and is not intended to provide, and should not be relied upon for, accounting, legal or tax advice or investment recommendations. Where the information contained in this document has been obtained or derived from third-party sources, the information is from sources believed to be reliable, but Letko, Brosseau & Associates Inc. has not independently verified such information. No representation or warranty is provided in relation to the accuracy, correctness, completeness or reliability of such information.