Wednesday, January 2, 2013

Provincial Solvency: Who Is Most Likely To Default?

A fascinating report by Marc Joffe at the Macdonald-Laurier Institute entitled "Provincial Solvency and Federal Obligations" examines what would happen to Canada, in particular the provinces, if a European-style debt crisis washed ashore.  Here is a quote from the executive summary:

"As recent events in the Eurozone show, confederations of largely independent governing units contain a serious flaw: when an individual member encounters fiscal distress, the union and its more financially stable members face pressure to bail it out. Citizens in other parts of the confederation shoulder the costs of assisting the fiscally challenged government, yet have no influence over its policies. Since bondholders are aware that bailouts happen, there is a chance that bond yields for federation members reflect the possibility of a bail out. If this is the case, yields do not correctly signal the risks arising from each member’s fiscal policies. Members can run large deficits without facing the wrath of the so-called “bond vigilantes”.

Let's dive in and take a closer look at Mr. Joffe's analysis.

As we all know, Canada's provinces receive a substantial portion of their funding from federal government transfers be it for health, social and other program spending including infrastructure and transportation among others.  The downside of these transfers results from the concept of moral hazard; provinces are free to spend and spend and spend until they reach unsustainable debt levels because the perception is that the federal government will be there to bail them out.  In case you weren't around at the time, Canada's federal government bailed out five of ten provinces during the Great Depression so the concept of a federal bailout is not without precedence.  Let's take a brief look at those bailouts:

1.) Alberta (1935 - 1936) - debt default on $33.4 million in principal and $28.6 million in interest requiring a $47.3 million bailout.

2.) Newfoundland (1932) - public debt reached $90 million with impending default on interest owing requiring a $1.25 million bailout from the federal and United Kingdom governments.

3.) Manitoba, Saskatchewan, Alberta and British Columbia (1932 to 1937) - loans totalling $131.99 million were granted by the federal government to the four western provinces to prevent them from defaulting.  Had Alberta not received this funding, it likely would have defaulted prior to 1935 - 1936 as noted above.

Let's go back to the present.  Here is a chart showing the current net debt, net debt per capita and net debt-to-GDP ratio for the 10 provinces:

Obviously, thanks to massive resource revenues, Alberta is in the best fiscal position followed relatively closely by Saskatchewan, a province that was in very poor fiscal condition in the early 1990s.  Quebec is in the worst fiscal position when measured using debt-to-GDP and net per capita debt metrics followed by Ontario.  Please note that off-balance sheet liabilities including items like Newfoundland and Labrador Power, Hydro-Quebec, Hydro One, Saskatchewan Power Corporation and others are not included in the above net debt figures.

Here is a chart showing provincial bond yields across the maturity spectrum from one year to thirty years:

Note that despite the huge differences in indebtedness amongst provinces, the yields are not substantially different suggesting that the bond market may be pricing in a federal government debt guarantee.

The Canadian government is now the beneficiary of one of the world's highest sovereign bond ratings, a solid AAA.  Provincial bond ratings are not as strong, ranging from a high of AAA for Alberta to a low of A (low) for Prince Edward Island on the Dominion Bond Rating Services scale as shown here along with the credit ratings from Moody's and S&P:

This means that Alberta is seen to have the lowest chance of defaulting (lowest risk) and PEI is seen to have the highest chance of defaulting.  In Alberta's case, they share the AAA rating with the federal government.

The chances of defaulting rise with time, that is, the longer the bond, the higher the risk of default as one works one's way down the ratings list.  Bonds with the highest provincial rating have a 0.0003 percent chance of defaulting in one  year rising to 0.1040 percent in 30 years.  On the other hand, bonds with the lowest provincial  rating have a 0.1280 percent chance of defaulting in one year, rising to a substantial 13.9591 percent chance in 30 years.  Taking this data into consideration, here is a chart showing the probability of each province defaulting based on their three credit ratings over the maturity spectrum from one to thirty years:

Notice that PEI has the highest chance of defaulting, reaching a probability of 9.26 percent in 30 years.  Alberta has the lowest chance of defaulting at a probability of only 0.1 percent in 30 years.  

While Mr. Joffe's analysis goes on to look at various simulations, I think that's enough for this posting.  If you wish to look further into this fascinating and somewhat frightening analysis, here is the link to his paper.  While the chances of a provincial default by any of Canada's ten provinces is remote, particularly over the next decade, aging populations, deficits that just won't disappear accompanied by rising debt levels and the potential of a return to higher levels of interest rates suggest that the risk of default is likely to rise rather than fall, particularly for Canada's less economically diverse and poorer provinces.  Unless, of course, the federal government steps in again.

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