The Sovereigntists Meet the Bond Vigilantes

With the prospect of a PQ Government in Quebec after next Tuesday’s election and a third referendum (a syndrome called the “neverendum”) on the horizon, I will reflect a bit on how global capital markets – the bond vigilantes – might respond.

There is some relevant historical precedent. In the run-up to the too-close-to-call 1995 referendum, international capital markets refused to buy new Canadian public sector debt. At the time, I was on the board of the Ontario Transportation Capital Corporation, then responsible for building Highway 407. We wanted to replace the provincial treasury bills that were funding the project with long term debt, and were given that alarming news by the Ontario Ministry of Finance.

Since 1995, Canada’s fiscal position has become much more secure relative to that of other countries. On the other hand, the bond vigilantes are much faster to pounce on countries whose finances are at all suspect.

Quebec’s public sector debt now stands at about 50 percent of gross provincial product. Debt service costs approximately $10 billion and consumes 11 percent of the government budget. The critical question is what will happen to the federal debt in the event Quebeckers were to vote for sovereignty in a future referendum. Sovereigntists will ignore the question or obfuscate. The federal government will argue that the debt was incurred by the entire nation, that federal assets in Quebec (the St. Lawrence Seaway, airports, federal buildings, national parks) will remain in situ and would thus become the property of a sovereign state of Quebec, and that therefore an independent Quebec must assume its fair share of the federal debt.

If we assume that a fair division of federal debt results in Quebec assuming its per capita share of the debt (24 percent, based on the 2011 Census), then an independent Quebec’s debt would increase to approximately 90 percent of gross domestic product (as shown in a recent briefing note entitled Quebec Election: Handle with Care posted on the Pimco Canada website). If we then assume that Quebec would be able to pay the same interest rate on its additional debt as on its current debt, then debt service costs would increase to close to 20 percent of the government budget.

Enter the bond vigilantes. Public debt of 90 percent of GDP is close to the situation in Greece, Italy, or Spain. If the bond vigilantes are skeptical about the long-term viability of the public finances of a sovereign Quebec, they would demand a substantially greater risk premium for debt issued by a sovereign Quebec than by the Canadian province of Quebec. The downward financial spiral faced by Greece or Italy could become a reality for Quebec. So virtually the first action of a sovereign Quebec government would be to seek a bailout.

If the sovereigntists’ Achilles heel is therefore public debt, then the federal government could exploit it. As soon as a sovereigntist government begins to prepare for a referendum, the federal government should enact a Fiscal Responsibility Act that would be parallel to the Clarity Act. (Recall that the latter requires a clear referendum question passed by a supermajority as a prerequisite for negotiating Quebec sovereignty.) The Fiscal Responsibility Act would stipulate that a sovereign Quebec would have to accept its per capita share of the federal debt. The Fiscal Responsibility Act would be intended to so substantially increase the economic cost of sovereignty for Quebeckers that it would dissuade them from voting for it in a referendum.

What I have outlined here is one of the key sticks the Harper Government could use to keep Quebec in confederation. But what carrots could it provide? It is a majority government with minimal representation from Quebec. Prime Minister Harper, to his credit, has achieved a level of fluency in French that, unfortunately, few members of his Cabinet or caucus can match. On a host of issues – for example social policy, cultural policy, and the long-gun registry – the Conservatives are completely out of step with Quebec. The Harper Government will have to do some serious thinking about how it can present a more welcoming face to Quebeckers if it is still in power during another referendum. Threatening to saddle Quebec with an unsustainable debt burden may be necessary to preserving the Canadian confederation, but it will not be sufficient.


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