How Big Is Ontario's Debt Problem?

May 4th, 2015

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This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

I didn't want to publish this until the elections were over, because I didn't want to appear political.

As most of you probably know, Ontario held its election on June 12. One of the main issues of the election centered around the province's budget deficit. The Liberals promised a budget that would increase spending in the short term, which would increase the annual deficit and the total debt that the province owes. The Progressive Conservatives proposed a budget that would rein in spending, which would cut the deficit and the debt.

I think now is as relevant a time as any to review just how big Ontario's debt problem is.

Last year, the Fraser Institute released a report that gave a detailed account of the problem. Drawing heavily from the report, as well as some other sources, I will explain the problem in plain language and give my thoughts as to what the late Liberal election win will mean to the province.

How Big Is The Debt Problem?

As of March 31, 2014, the total amount of Ontario government's debt stood at $296 billion. However, just looking at the total number won't give us a good sense of the problem. Instead, it makes more sense to view the debt in two ways: A) as a percentage of GDP, and B) as a percentage of the government's revenue.

We can think of a province's GDP as the combined income of Ontarian residents. Therefore, if a province's debt stood at 10% of its GDP, then the government could theoretically tax everyone an extra 10% and pay off all outstanding debt.

As of 2013, Ontario's GDP stood at $692 billion. The Ontarian economy has probably grown since then, but not by much. Assuming that the GDP stands at roughly $700 billion, that means Ontario's debt is currently about 42% of its GDP. Note that this is just the province's debt, and it doesn't include the Federal government debt.

Right now Ontario is the second most highly indebted province in Canada. The only province that has a higher debt load is Quebec, which has around 51% debt to GDP. However, Quebec's debt load is stable, while Ontario's debt load is increasing.

Another way to look at the size of Ontario's debt is to compare it to its revenue.

Currently, Ontario's debt amounts to roughly 2.4 times the size of its revenue, which is pretty high. Also, the size of Ontario's debt is such that at current interest rates, 10% of the government's revenue is used to pay interest. That means 10% of Ontarians' tax dollars goes toward bond holders, as opposed to paying for schools, healthcare, etc.

How Did Ontario Get to This Point?

So how did Ontario accumulate its debt? To understand this, let's first talk about how the government accumulates debt.

Governments accumulate debt the same way households and corporations accumulate debt: they spend more than they take in. To finance the shortfall (i.e. the deficit), the government borrows from investors by selling bonds. Therefore, we can think of debt as the accumulated deficit of the government over the years.

As recently as 2008, Ontario had less than $160 billion in debt, which amounted to roughly 27% of its GDP. This ratio had remained somewhat stable over the years before.

But in 2008-2009, the financial crisis happened and things began to change. For one, Ontario started to take in less tax revenue as people lost their jobs. For another, they spent heavily on rescuing the ailing auto industry and they ramped up infrastructure spending to stimulate the economy.

At the same time, they allowed other types of spending to increase sharply. Healthcare costs have increased more than 7% per year for the past 10 years, while education increased by 10% over the same period. Healthcare represented 42% of the government's spending in 2013, while education represented 21%.

As a result, the government went from a small surplus in 2008 to a $19 billion deficit in 2009, and it now expects to record a deficit of $14 billion in 2014. In other words, they've essentially added 3% of their GDP's worth of debt every year beginning in 2009.

The Future Of Ontario Debt

Obviously the government can't accumulate 3% worth of GDP to its debt forever. Sooner or later, interest payments will take up far too much of the budget. At some point, the government will have to either cut spending, and/or increase taxes to balance the budget again. The question is when.

Liberals have won the election with a budget that promises to increase spending in the short term. This means the government will continue to record large deficits in the next few years.However, whether they actually carry out this promise depends on the actions of the ratings agencies and bond investors.

Ratings agencies such as Moody's and Standard and Poors (S&P) play an important role in the bond market by grading the safety of bonds. If they think a bond is safe, they will assign a high rating (AAA being the highest of ratings) to the bond, and vice versa.

Because bonds with high ratings are considered safe, they generally command lower interest rates. On the other hand, investors get nervous holding bonds with lower ratings, so they demand higher interest rates to compensate for the risk.

Currently, Moody's gives an AA2 rating for Ontario's bonds, which is the third highest investment grade. S&P on the other hand, gives it an AA- rating, the 4th highest rating. Notably, S&P also has a negative outlook on the bond, which means they may downgrade Ontario's rating in the near future.

Although the bonds are still considered safe, further downgrades could shake investors' confidence in the bonds, and result in higher interest rates. If that happens, Ontario will have to pay more to service its debt, which will further increase the deficit. This could start a vicious cycle in which higher interest rates result in higher deficits, which leads to further loss in confidence and even higher interest rates. This is exactly what happened to Greece.

Government officials generally understand this problem, which is why many people believe the Ontario government won't increase spending as promised if interest rates start to rise. Though no one's quite sure when interest rates will rise, at least some journalists are starting to sound the alarm.

What The Future Holds

In summary, in terms of the ability to repay the debt, no one's ringing any alarm bells yet. At 10% of revenue, the Ontario government can still afford to pay interest on the debt (though it hurts). However, if debt continues to balloon in the future, interest payments will also go up and at some point, the government's ability to repay will come into question.

The longer Ontario continues to spend more than it takes in, the more painful it will be when it has to rein in spending. At double the debt load, assuming interest rates don't go up (though they probably will), reducing the debt will require using more than 20% of the government's revenue to pay off debt holders. This will require very severe cuts in government services and/or tax increases.

I believe the government will end up making the right choices. But it won't be pleasant for any Ontarian.

This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

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