The following article projecting Canadian Federal debt and deficits as a fraction of GDP appeared in Feb 2010 here. I want to keep tabs, remember the forecasts, so that we might check their math later.
The implicit assumption is a non-correlation of government fiscal policy and GDP growth (or contraction). Another is that the maximum error they could have in their projections is +/- 1% of GDP growth. Boy, they must be good! Bow to the economic masters of the universe! Can you tell I am skeptical?
So, let’s just keep score, shall we? We’ll revisit this page in a year or two. Here comes QE2 down south….
The Federal Debt and Rising Interest Rates: Should We Be Worried?
Édison Roy-César
International Affairs, Trade and Finance Division
Parliamentary Information and Research Service
Library of Parliament
8 February 2010
PDF (280 Kb, 9 pages)
Contents
- Introduction
- Changes in the Federal Debt
- Federal Debt – Scenarios
- A. Federal Debt and Economic Growth
- B. Federal Debt and Rising Interest Rates
- Conclusion
- Endnotes
Introduction
The Bank of Canada recently announced that interest rates would rise in 2010.(1) This announcement confirmed what many commentators on the economy had expected for months. An increase in the Bank of Canada key interest rate will end a period of uncommon monetary easing. With regard to public finances, the return of federal deficits has already marked a significant reversal. Rising interest rates signal the end of a virtuous cycle in debt management.
After dropping steadily for over a decade, the cost of servicing the debt,(2) expressed as a percentage of total federal revenues, will very likely increase in the coming years, marking a sharp break from the previous period.(3) Reducing the cost of servicing the debt – and of course reducing the debt itself – is very important. Without this reduction, which led to budget surpluses in 11 of the 14 years from 1995 to 2008, the federal government would have incurred budget deficits throughout this period, except in 1999 and 2000.(4)
The purpose of this paper is to evaluate likely changes in the national debt and the cost of servicing the debt using various economic growth and interest rate increase scenarios.
Changes in the Federal Debt
The federal debt(5) rose steadily from 1990 to 1996 due to significant budget deficits during that period (see Figure 1). The following 10 years, from 1997 to 2007, saw successive budget surpluses and a general decrease in market interest rates. These two factors served to reduce the relative size of the federal debt as a proportion of the Gross Domestic Product (GDP), from 63% to 29%, and reduced the annual cost of servicing the debt by $9.8 billion.(6)
Figure 1 – Changes in the Federal Debt, 1990–2011
Source: Figure prepared by the author based on information in Department of Finance, Fiscal Reference Tables, (271 Kb, 67 pages) October 2009, and Department of Finance, Update of Economic and Fiscal Projections, (867 Kb, 24 pages), Table 1, “Summary Statement of Transactions,” September 2009, p. 9.
The federal debt increased in fiscal year 2008–2009 and will increase in the coming years (see projections in Figure 1) due to lower tax revenues and higher expenses owing to the economic crisis as well as to federal fiscal stimulus measures.
Federal Debt – Scenarios
Changes in the federal debt and the cost of servicing it are likely to be influenced by two key factors: the country’s economic growth and the expected increase in market interest rates. To determine the impact of these factors in the coming fiscal years, we will examine each of them using various scenarios.
A. Federal Debt and Economic Growth
Economic growth as measured by the nominal GDP(7) is one of the main factors affecting the government’s budget balance and in turn the federal debt and the cost of servicing the debt.
Table 1 shows the impact of growth in the real GDP that is one percentage point higher or lower than that presented in the basic scenario projected by the Department of Finance in September 2009.(8) Given the uncertainty surrounding projections of growth in the real GDP in the current economic climate, it is reasonable to believe that the department’s projections might underestimate or overestimate this order of GDP growth and therefore overestimate or underestimate the federal debt and the cost of servicing it.
| Basic Scenarioa | Growth in Real GDP | |||||
|---|---|---|---|---|---|---|
| One Percentage Point Lower Than Projected in the Basic Scenario |
One Percentage Point Higher Than Projected in the Basic Scenario |
|||||
| 2010-2011 | 2011-2012 | 2010-2011 | 2011-2012 | 2010-2011 | 2011-2012 | |
| Budget revenues ($B) | 233.1 | 250.9 | 230.4 | 248.1 | 235.8 | 253.7 |
| Program expenses | 244.7 | 240.6 | 245.1 | 241.0 | 244.3 | 240.2 |
| Servicing the public debt | 33.7 | 37.7 | 33.7 | 37.8 | 33.7 | 37.6 |
| Total expenses ($B) | 278.4 | 278.3 | 278.8 | 278.8 | 278.0 | 277.8 |
| Budget balance | −45.3 | −27.4 | −48.4 | −30.7 | −42.2 | −24.1 |
| Federal debt | 564.9 | 592.3 | 568.0 | 598.7 | 561.8 | 585.9 |
| Federal debt (variation in $B) | – | – | 3.1 | 6.4 | −3.1 | −6.4 |
| Servicing the debt (variation in $B) | – | – | 0.0 | 0.1 | 0.0 | −0.1 |
| Federal debt (% of GDP) | 35.6% | 35.4% | 36.2% | 36.2% | 35.1% | 34.7% |
| Servicing the debt (% budget revenues) | 14.5% | 15.0% | 14.6% | 15.2% | 14.3% | 14.8% |
| a. Scenario projected in Department of Finance, Update of Economic and Fiscal Projections, Table 1, “Summary Statement of Transactions,” September 2009, p. 9. Source: Table prepared by the author based on information in Department of Finance, Department of Finance, Update of Economic and Fiscal Projections, (867 Kb, 24 pages), Table 1, “Summary Statement of Transactions,” September 2009, p. 9, and Department of Finance, Canada’s Economic Action Plan, Budget 2009, (1.2 Mb, 343 pages) 27 January 2009, p. 258. |
||||||
These figures suggest that a one percentage point increase in real GDP over the Finance Department’s economic projections would reduce the federal debt by $3.1 billion in 2010–2011 and by $3.3 billion in 2011–2012, for a total reduction of $6.4 billion by 2011–2012. The impact of that economic growth on the federal debt – and on the cost of servicing it – would be relatively small, however, given the magnitude of the budget deficits forecast for the coming fiscal years: they are estimated at $45.3 billion and $27.4 billion in 2010–2011 and 2011–2012 respectively.
B. Federal Debt and Rising Interest Rates
As discussed earlier, market interest rates are likely to increase in 2010. Table 2 shows the impact of a 50-basis-point and a 100-basis-point increase on the Finance Department’s projections.
| Basic Scenarioa | Scenario with a 50-Basis-point Increaseb in All Interest Rates |
Scenario with a 100-Basis-point Increaseb in All Interest Rates |
||||
|---|---|---|---|---|---|---|
| 2010-2011 | 2011-2012 | 2010-2011 | 2011-2012 | 2010-2011 | 2011-2012 | |
| Budget revenues ($B) | 233.1 | 250.9 | 234.1 | 252.0 | 235.1 | 253.1 |
| Total expenses ($B) | 278.4 | 278.3 | 279.7 | 280.2 | 281.0 | 282.0 |
| Budget balance | −45.3 | −27.4 | −45.6 | −28.2 | −45.9 | −28.9 |
| Federal debt | 564.9 | 592.3 | 565.2 | 593.4 | 565.5 | 594.4 |
| Budget balance (variation in $B) | – | – | −0.3 | −0.8 | −0.6 | −1.5 |
| Federal debt (variation in $B) | – | – | 0.3 | 1.1 | 0.6 | 2.1 |
| Federal debt (% of GDP) | 35.6% | 35.4% | 35.6% | 35.5% | 35.7% | 35.5% |
| a. Scenario projected in Department of Finance, Update of Economic and Fiscal Projections, Table 1, “Summary Statement of Transactions,” September 2009, p. 9. b. One basis point equals 0.01%. Source: Table prepared by the author based on information in Department of Finance, Update of Economic and Fiscal Projections, (867 Kb, 24 pages), Table 1, “Summary Statement of Transactions,” September 2009, p. 9, and Department of Finance, Canada’s Economic Action Plan, Budget 2009, (1.2 Mb, 343 pages), 27 January 2009, p. 258. |
||||||
According to these calculations, a 50-basis-point increase in all interest rates in 2010 would increase the federal debt by $300 million in fiscal year 2010–2011 and by $800 million in 2011–2012. With an increase of 100 basis points in all interest rates in 2010, the federal debt would increase by $600 million in 2010–2011 and by $1.5 billion in 2011–2012. These differences are relatively small, given the magnitude of the anticipated budget deficits.
Conclusion
This analysis, shows that the impact of a potential increase in economic growth on the federal deficit – and accordingly on the cost of servicing the debt – would likely be relatively low, given the large budget deficits anticipated for the coming fiscal years. Moreover, the impact would be at least partially offset by the increase in all interest rates in 2010. This suggests that, in the medium term, economic growth will not significantly affect the size of the federal debt or the cost of servicing it.
The latest Department of Finance projections indicate that the cost of servicing the debt will increase by $6.7 billion by 2011–2012.(9) This increase, which is roughly equal to the total budget appropriations to the Department of Indian and Northern Affairs in 2008–2009, will reduce the government’s fiscal flexibility in the coming years.(10)
That said, one should bear in mind that Canada has the lowest net-debt-to-GDP ratio of all G7 countries and that it is part of the select club of 18 countries with a long-term AAA credit rating.(11) Moreover, Canada is one of the few countries in recent history that has gone from chronic budget deficits to several successive budget surpluses.
- Bank of Canada, “Bank of Canada maintains overnight rate target at 1/4 per cent and reiterates conditional commitment to hold current policy rate until the end of the second quarter of 2010,” News release, 19 January 2010.
- The cost of servicing the debt is equal to all government expenditures to pay interest on the debt.
- Between 1995 and 2008, the gradual decrease in the federal debt and the general drop in interest rates in the Canadian market reduced by $18.4 billion the amount spent annually servicing the debt. See Department of Finance, Fiscal Reference Tables, (271 Kb, 67 pages) October 2009, Table 1, p. 9.
- In 1999 and 2000, the Canadian economy benefited from exceptionally high economic growth in the United States. As a result, the difference between government’s revenues and expenditures was higher than the cost of servicing the debt and would have been higher than the cost of servicing the debt had the cost of servicing the debt stayed at its peak 1995 level.
- For our purposes, the federal debt refers to the “accumulated deficit” obtained by subtracting financial assets (cash, reserves, loans) and non-financial assets (capital assets) from the gross debt (federal government’s total expenses). The gross debt is made up of the market debt (62%), the pension plan and other liabilities (23.7%), creditors and accrued liabilities (13.9%), and changes in the value of market debt and lease and purchase agreements (0.4%).
- Department of Finance Canada (October 2009), Table 1, p. 9.
- Growth in the nominal GDP is equal to the growth in the real GDP plus the rate of inflation. The nominal GDP represents, in a sense, the tax base from which the government can levy all kinds of taxes.
- Department of Finance, Update of Economic and Fiscal Projections, (867 Kb, 24 pages), Table 1, “Summary Statement of Transactions,” September 2009, p. 9.
- Department of Finance Canada (September 2009), Table 1, p. 9.
- Public Accounts of Canada 2009, Volume 1: Summary Report and Financial Statements, (1.6 Mb, 304 pages) “Total expenses by segment,” p. 2.13.
- The AAA credit rating means that Canada has a strong ability to meet its liabilities.