Provincial Solvency and Federal Obligations Marc Joffe Foreword by Don Drummond

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Provincial Solvency and Federal Obligations Marc Joffe Foreword by Don Drummond Provincial Solvency and Federal Obligations MARC JOFFE Foreword by Don Drummond A Macdonald-Laurier Institute Publication October 2012 True North in Canadian Public Policy Board of Directors Advisory Council CHAIR Purdy Crawford Rob Wildeboer Former CEO, Imasco, Counsel at Osler Hoskins Chairman, Martinrea International Inc., Toronto Jim Dinning Former Treasurer of Alberta MANAGING DIRECTOR Brian Lee Crowley Don Drummond Former Clifford Clark Visiting Economist Economics Advisor to the TD Bank, Matthews Fellow in at Finance Canada Global Policy and Distinguished Visiting Scholar at the School of Policy Studies at Queen’s University SECRETARY Brian Flemming Lincoln Caylor International lawyer, writer and policy advisor Partner, Bennett Jones, Toronto Robert Fulford Former editor of Saturday Night magazine, columnist TREASURER with the National Post, Toronto Martin MacKinnon CFO, Black Bull Resources Inc., Halifax Calvin Helin Aboriginal author and entrepreneur, Vancouver DIRECTORS Hon. Jim Peterson John Beck Former federal cabinet minister, Partner at Chairman and CEO, Aecon Construction Ltd., Fasken Martineau, Toronto Toronto Maurice B. Tobin Erin Chutter The Tobin Foundation, Washington DC President and CEO, Puget Ventures Inc., Vancouver Navjeet (Bob) Dhillon Research Advisory Board CEO, Mainstreet Equity Corp., Calgary Janet Ajzenstat Keith Gillam Professor Emeritus of Politics, McMaster University Former CEO of VanBot Construction Ltd., Toronto Brian Ferguson Wayne Gudbranson Professor, health care economics, University of Guelph CEO, Branham Group, Ottawa Jack Granatstein Stanley Hartt Historian and former head of the Canadian Chair, Macquarie Capital Markets Canada War Museum Les Kom Patrick James BMO Nesbitt Burns, Ottawa Professor, University of Southern California Peter John Nicholson Rainer Knopff Former President, Canadian Council of Academies, Professor of Politics, University of Calgary Ottawa Larry Martin Rick Peterson George Morris Centre, University of Guelph President, Peterson Capital, Vancouver Christopher Sands Jacquelyn Thayer Scott Senior Fellow, Hudson Institute, Washington DC Past President, Professor, Cape Breton University, William Watson Sydney Associate Professor of Economics, McGill University For more information visit: www.MacdonaldLaurier.ca MLIStandardPages06-2012.indd 1 12-06-05 2:51 PM True North in Canadian Public Policy Board of Directors Advisory Council CHAIR Purdy Crawford Rob Wildeboer Former CEO, Imasco, Counsel at Osler Hoskins Chairman, Martinrea International Inc., Toronto Jim Dinning Table of Contents Former Treasurer of Alberta MANAGING DIRECTOR Brian Lee Crowley Don Drummond Foreword .................................................................................................................. 4 Former Clifford Clark Visiting Economist Economics Advisor to the TD Bank, Matthews Fellow in Executive Summary ................................................................................................ 5 at Finance Canada Global Policy and Distinguished Visiting Scholar at the Introduction ............................................................................................................. 7 School of Policy Studies at Queen’s University Outstanding Debt By Province ............................................................................... 7 SECRETARY Brian Flemming Measuring Debt ................................................................................................ 7 Lincoln Caylor International lawyer, writer and policy advisor Direct and Indirect Debt ..................................................................................10 Partner, Bennett Jones, Toronto Robert Fulford Current Yields and Spreads on Provincial Debt .....................................................12 Former editor of Saturday Night magazine, columnist TREASURER with the National Post, Toronto Theoretical Interest Rates in the Absence of Federal Support ............................13 Martin MacKinnon Interest Rate Drivers ........................................................................................14 CFO, Black Bull Resources Inc., Halifax Calvin Helin Aboriginal author and entrepreneur, Vancouver Estimating Default Probabilities .....................................................................15 DIRECTORS Hon. Jim Peterson Default Probabilities Derived from a Model ....................................................15 John Beck Former federal cabinet minister, Partner at Loss Given Default ...........................................................................................21 Chairman and CEO, Aecon Construction Ltd., Fasken Martineau, Toronto Expected Loss ................................................................................................. 28 Toronto Maurice B. Tobin Risk Aversion Factor ....................................................................................... 29 Erin Chutter The Tobin Foundation, Washington DC Actual Versus Theoretical Interest Rates – Is There a Federal Subsidy? .......31 President and CEO, Puget Ventures Inc., Vancouver Conclusion ............................................................................................................. 34 Navjeet (Bob) Dhillon Research Advisory Board CEO, Mainstreet Equity Corp., Calgary Appendix A: More on Interest Rate Decomposition ........................................... 35 Janet Ajzenstat Appendix B : Evidence from Past Defaults and Fiscal Crises .............................. 37 Keith Gillam Professor Emeritus of Politics, McMaster University Former CEO of VanBot Construction Ltd., Toronto Alberta Default – 1935/1936 ............................................................................ 37 Brian Ferguson Other Provinces during the Great Depression ............................................... 39 Wayne Gudbranson Professor, health care economics, University of Guelph CEO, Branham Group, Ottawa Newfoundland Bailout – 1932 ..........................................................................41 Jack Granatstein Saskatchewan Fiscal Crisis – 1993 .................................................................. 42 Stanley Hartt Historian and former head of the Canadian Newfoundland and Labrador Fiscal Crises – Early 1990s and Early 2000s ... 43 Chair, Macquarie Capital Markets Canada War Museum Australia and New Zealand Interest Adjustments – 1931 and 1933 ................ 44 Les Kom Patrick James New South Wales (Australia) Default – 1931 ................................................... 45 BMO Nesbitt Burns, Ottawa Professor, University of Southern California Arkansas (US) Default – 1933.......................................................................... 46 Peter John Nicholson Rainer Knopff Canadian Municipal Defaults – 1930s ............................................................. 46 Former President, Canadian Council of Academies, Professor of Politics, University of Calgary Conclusion ...................................................................................................... 47 Ottawa Larry Martin Rick Peterson George Morris Centre, University of Guelph About the Author ................................................................................................... 48 President, Peterson Capital, Vancouver Christopher Sands Jacquelyn Thayer Scott Senior Fellow, Hudson Institute, Washington DC Past President, Professor, Cape Breton University, William Watson Sydney Associate Professor of Economics, McGill University The author of this document has worked independently and is solely responsible for the views presented here. The opinions are not necessarily those of the Macdonald-Laurier Institute, its Directors or Supporters. For more information visit: www.MacdonaldLaurier.ca MLIStandardPages06-2012.indd 1 12-06-05 2:51 PM Foreword by Don Drummond The Macdonald-Laurier Institute publication “Provincial Solvency and Federal Obligations” by Marc Joffe provides a number of important lessons for Canadian fiscal policy authorities at the federal, provincial and territorial levels. The analysis suggests that the combination of future economic conditions, featuring more modest output increases than historically, and “status quo” policies, in particular the continuation of fairly rapid growth in health care spending, will put a number of provinces into debt positions that could lead to defaults. Interestingly, Alberta, despite its current net asset position, has the highest longer-term default probability. If credit rating agencies and markets share the perspectives from this report’s analysis, then in theory the provinces should be facing higher interest rate spreads over federal rates. The author surmises that the relatively low spreads observable vis-a-vis federal rates are due to the assumption that the federal government will bail out any defaulting provincial government, as was done on several occasions in the 1930s. The complex analysis leading to this conclusion leaves a lot of room for question. Perhaps the agencies and markets believe provinces will act more responsibly to correct soaring debt than implied by the report’s mechanical extrapolations. Perhaps they don’t accept the study’s definition of what debt burdens lead to high default risk. Nonetheless, the study does bring to our attention a number of very important issues that are highly relevant to current and future fiscal policy in Canada. As is being recognized now in Europe, the study points out the difficulty of operating an economic and monetary
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