Drop in Canadian Dollar Reflects Budget Concern

A major portion of Canada's debt is funded by foreigners

CANADA'S federal government came under fire last week as interest rates jumped, stocks fell, and the Canadian dollar weakened, raising fears that this nation's economic recovery might be crushed.

Canada's dollar fell in value to 71.62 cents (United States) - a low not seen in seven years - before bouncing back late in the week. The Toronto Stock Exchange index fell 7.3 percent in two weeks. And short-term interest rates rose to 6.21, despite Canada's low 1.8 percent inflation rate.

Opposition politicians and financial economists quickly pointed the finger at Finance Minister Paul Martin, saying investors in Canadian bonds lacked confidence that his February budget was a real commitment to cut the federal deficit to 3 percent of gross domestic product (GDP) in two years from 6.4 percent in the most recent fiscal year.

That's hogwash, Mr. Martin said in so many words. He claimed that the budget deficit targets would be met. A day later, Gordon Thiessen, Canada's new central banker, also offered soothing words. Soon after, bond market selling in the US and Canada cooled, Canada's stock markets calmed, and its currency bounced back a little. The faces of Canadian investors became less grim. Public discussion of who or what is at fault continues, but the volume has dropped.

Yet there remains an acute awareness among Canadian economists and politicians that the blow from the bond-market turmoil has hit Canada harder than it has the US.

Higher debt costs. Debt-service costs on the $511 billion (Canadian; US$369 billion) owed by the federal government are rising. For every percentage point interest rates go up, an additional $1.7 billion is owed. Interest rate hikes since February have increased the government's debt by as much as $2 billion, raising fears this will blow the budget.

Long-term economic damage. US economists say damage to the US recovery will be small if long-term interest rates do not rise much higher. Canadian economists, by contrast, say interest rates will fall back much more slowly, if at all. That may dampen home and car sales, discourage investment, and keep the unemployment rate in double digits.

Continued weak currency. While exporters cheer a lower Canadian dollar, many others worry that Canada is moving toward a crisis of confidence among foreign investors. Declining confidence is evidenced clearly in the fall of the Canadian dollar. The Bank of Canada spent $3.25 billion in March defending the Canadian dollar as it fell almost 2 cents (US) worldwide.

Political uncertainties. Can Quebec, Ontario, and the federal government master their budget deficits? Will a separatist government be elected in Quebec this fall?

``Uncertainties about [Canada's] situation appear to have been a contributing factor to the larger rise in both short-term and longer-term rates than in most other major countries, as well as to a weaker Canadian dollar,'' Mr. Thiessen said.

Leo de Bever, chief economist at Nomura Canada, says he agrees that Canada has been hit harder than the US, in part because global money managers and other investors can just as easily invest in US bonds. Thus, they can demand an interest-rate premium to invest in Canada.

Evidence of this is that the ``spread'' - the difference between US short-term interest rates and Canadian rates - is now more than two percentage points higher than it was two weeks ago, Mr. De Bever says. ``This whole thing may have started for fundamental [economic] reasons in the States, but what we're seeing is that once it got going, the bond-market turmoil hit Canada harder,'' he says.

The jitters are most severe among foreign investors, whose concerns have a major impact on Canada's interest rates and dollar.

Mr. Martin's budget, for example, is criticized as not being reassuring to those investors because it allows Canada's federal debt to rise from $511 billion currently to $583 billion over the next two years. That means Canada's overall indebtedness, now 72 percent of GDP, will rise to 75 percent in that time period.

Three of four principal debt-rating agencies have dropped Canada's federal debt rating from triple-A. Moody's, however, still maintains a top rating. The situation is compounded because much of the debt issued by the provinces of Ontario and Quebec is held by foreigners.

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