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Weekly Commentary

Can Canada Remain “The Cleanest Dirty Shirt in the Fiscal Laundry Basket”?

November 17, 2023
Randall Bartlett
Senior Director of Canadian Economics

With Moody’s cutting the US federal government’s credit outlook to negative late last week amid ongoing political dysfunction in Washington, eyes have turned to Canada. In the lead-up to the Government of Canada’s Fall Economic Statement (FES) this coming Tuesday, the key question is: Could Canada suffer a similar fate and possibly lose its triple-A credit rating?


In the short term, the answer is probably no. Canada is often called “the cleanest dirty shirt in the fiscal laundry basket.” That’s because when you juxtapose the federal government’s deficit outlook here versus in the US, there is absolutely no comparison (graph 1). The US federal government is running, and plans to continue to run, unprecedented budget deficits External link. This link will open in a new window. outside of a recession. Canada is nowhere close. But that’s the federal government. What about when you include states and provinces as well as local governments? Again, forget about it. Even when you compare Canada’s public finances to other countries’ on a consolidated basis as the IMF does, our deficits are smaller than those of our G7 peers, and Australia and Spain too (for those who don’t believe the G7 alone is an apt comparator).


Turning to debt, again Canada places well. While Canada is near the middle of the pack in the G7 in terms of gross debt across all levels of government as a share of GDP, it comes in dead last for net debt (graph 2). This is largely the result of Canada’s fully-funded national pension plans—the Canada Pension Plan and Quebec Pension Plan. Many other major advanced economies have looming future pension liabilities they haven’t set aside sufficient funds for. But even removing pension funds from the net government debt calculation as we did in a report External link. This link will open in a new window. earlier this year, Canada continues to rank near the top of the leader board as one of the major advanced countries with the least indebted public sectors. This is also true when just isolating the central government.


But here’s the rub. Canada is generally a price taker when it comes to interest rates. Beyond the very short term, the Bank of Canada’s policy rate has increasingly less influence over borrowing costs the further one goes out the yield curve. Instead, it’s US bond yields that primarily determine Canadian government bond yields at, say, 10‑ and 30‑year maturities. Because the US federal government has increased its borrowing program as interest from traditional US bond investors wanes, US Treasury yields have gone up. While this isn’t something Canadian legislators can control, they will have to contend with the higher borrowing costs it entails (graph 3).


Given the independence of the Bank of Canada and international influence on interest rates, the way governments in Canada can impact their borrowing costs is primarily through their own fiscal actions. As outlined previously, both consolidated and federal government deficits and debt as a share of GDP remain low in Canada relative to our international peers. But cracks are showing. First, the federal government has abandoned all ambition of ever returning to a balanced budget. And while fiscal forecasts show a return to a falling debt-to-GDP ratio at some point over the outlook, the Government of Canada’s resolve to make this happen seems to weaken with each new projection published. This worsening deficit and debt profile is entirely the result of ever higher spending, with each new fiscal document outlining an expenditure track that is higher than the one before (graph 4).


As we outlined in our recent federal FES preview External link. This link will open in a new window., we think this trend toward ever higher spending is set to continue given the deluge of uncosted announcements recently. We just won’t know by how much until the FES is published on Tuesday. However, ironically, only the federal government can reverse this expenditure trend. And it would be wise to do so before higher borrowing costs lead to deficit and debt dynamics that are beyond its control and ultimately take dramatic action to correct. Having the cleanest dirty shirt doesn’t mean we should stain it further.