Viewpoint - How would higher interest rates affect Quebec's debt service costs?
Publication estimating at 1.3 billion dollars the additional debt service costs incurred by the Quebec government in the case of a 2% increase in interest rates.
Quebec benefits from unusually low interest rates in financing its debt, making this heavy burden manageable, at least for the time being. But what will happen when borrowing costs rise? Lenka Martinek, chief strategist of Daily Insights at BCA Research estimates that a 2% increase in interest rates would require $1.3 billion in additional spending on debt service in 2018. And this scenario does not take account of a potential recession.
Media release :: Quebec’s debt: how much would higher interest rates cost?
|Interview with Lenka Martinek (CTV News, March 6, 2013)|
Viewpoint prepared by Lenka Martinek, chief strategist of Daily Insights at BCA Research, in collaboration with Youri Chassin, Economist at the MEI.
Direct government debt(1) in Quebec, at 47% of GDP, is higher than in any other Canadian province.(2) At present, Quebec's debt math is sustainable, but only precariously so. In particular, low interest rates have kept down its costs. Debt has risen from $76 billion in 2000 to $159 billion in 2012,(3) but average interest paid on the overall debt fell during the same period from 6.9% to 4.2%.(4) This explains why debt servicing costs have declined as a share of government revenues, from 14.8% to 10.9%, as shown in Figure 1 (visit iedm.org). But what happens if and when rates go up?
Rising borrowing costs
The decline in Quebec's borrowing costs has in fact had very little to do with fundamentals in Quebec, reflecting instead a global decline in interest rates. However, quantitative easing programs by central banks around the world will not last forever. Eventually, Quebec will face rising borrowing costs when interest rates normalize.
What would happen if interest rates, currently hovering around 4%, suddenly went up to 6% on new bonds, starting in January 2014? Applying this increase of two percentage points (or 200 basis points in financial parlance) to government bonds would gradually lead to higher debt service costs. These costs would be $1.3 billion more than otherwise in 2018, as illustrated in Figure 2 (visit iedm.org). The 6% rate would not affect a large portion of the debt, because the maturity of various bonds is spread over time, which means that average interest paid on the overall debt would climb only to 4.8%.
When bonds mature, they are often "rolled over" by the government, meaning the same amount is borrowed again by issuing new bonds to pay for the maturing ones. The new bonds issued to meet the government's financial needs serve above all to refinance existing debt and, to a lesser degree, to finance growth in the debt.
A close look at the government's debt schedule(5) suggests that rising interest rates can be manageable in the near term. For the next five years, from January 2014 to the end of 2018, about one-third of Quebec's debt matures. And at 4.8%, average interest paid on the overall debt does not seem problematic, remaining low by historical standards.
In the longer term, about 61% of debt does not mature until after 2018, which means that this portion of debt is completely shielded from the risk of higher interest rates until then. After this time horizon, however, uncertainty builds up. It becomes far more difficult to predict the future cost of borrowing, which will depend heavily on Quebec's financial outlook in the years ahead.
What debt level would be unsustainable?
There is no magic number indicating how much debt is too much debt. An economy with a high potential growth rate and access to low interest rates will be able to sustain a higher level of debt than would otherwise be the case. Both these conditions are cyclical, however, and a higher debt level can affect them. In their analysis of public debt and economic growth, economists Carmen Reinhart and Kenneth Rogoff ascertain that an increase in public debt beyond 90% of GDP reduces economic growth by four percentage points over the long term in developed countries.(6)
Also, as government debt rises, interest rates on bonds go up in recognition of the higher risk facing investors who hold government securities. Since the government will need the ongoing readiness of capital markets in order to finance its large stock of public debt at a reasonable price, this gives it little latitude to deviate from its balanced budget target. It also leaves the government with almost no room for unexpected factors such as a possible recession or a sharp rise in interest rates.
As we have seen, Quebec may enjoy low borrowing costs for now, but this will not last indefinitely. The current situation underscores why the government's first order of business should be sustained debt reduction to avoid having to make even more painful choices down the road.
1. There exist several concepts of public debt. Direct debt, used here, consists of bonds issued on the financial markets. Gross debt includes liabilities in the form of pension plans calculated using actuarial methods. Higher borrowing rates on bonds do not necessarily influence the actuarial value of pension payments to be made in the future. Public sector debt also includes the debts of other public bodies. Although the Quebec government is the ultimate guarantor of these debts, interest on them does not come out of the government budget. Direct debt is therefore the best debt concept to be used for the purposes of this Viewpoint.
2. Quebec Department of Finance, Budget Plan 2013-2014, p. D.19.
3. Idem, p. I.24. Although government accounting reform limits comparisons between these two years, there do not exist any more reliable data.
4. Quebec Department of Finance, Public Accounts 2000-2001, Volume I, p. 22, and Public Accounts 2010-2011, Volume I, p. 110.
5. Bloomberg, Debt distribution, Province of Quebec, Financial data available to subscribers, consulted on February 25, 2013.
6. Carmen M. Reinhart and Kenneth S. Rogoff, "Growth in a Time of Debt," American Economic Review: Papers and Proceedings, Vol. 100 (2010), pp. 573-578.