DBRS on Ontario’s 2009 Budget: Walking a Fine Line

The 2009 budget presented yesterday by the Province of Ontario (the Province or Ontario) signals a much more drastic deterioration in the fiscal and financial outlooks of the Province than DBRS had anticipated, with large deficits planned for the next four years and sharp increases in debt to levels unseen since the mid-1990s. While DBRS recognizes the need for governments to maintain key services and stimulate economic activity in recessionary times, it is concerned about the affordability of Ontario’s spending plan and the relatively slow pace of the planned fiscal recovery, which stands in contrast to plans presented so far by other Canadian provinces. This leaves limited room to weather further deterioration in economic conditions or a slower recovery than foreseen in the budget.

Faced with a shrinking manufacturing sector and an inflated spending base due to measures aimed at lessening the impact of the recession on its economy, the Province is now forecasting deficits of $14.1 billion in 2009-10, $12.2 billion in 2010-11 and $9.7 billion in 2011-12, with a slow return to balance planned over the following four fiscal years. This translates into annual deficits of $17 billion to $21 billion over the three-year period on a DBRS-adjusted basis (including capital expenditures on a pay-as-you-go basis rather than as amortized), or approximately 3% to 4% of GDP, which points to sizeable debt pressure ahead.

Revenues as measured by DBRS are projected to grow by 2.7% in 2009-10. Tax revenues will be down slightly, although the lost revenue should be more than offset by increased federal funding for social programs, infrastructure and training initiatives, as well as a first-ever equalization payment of $347 million. Earnings from government business enterprises are also expected to contribute to revenue growth. The budget proposes a major tax reform that will provide relief to individuals and businesses estimated at $15 billion over three years, including cash payments to individuals and families to ease the transition to a new harmonized sales tax and a 1% reduction in the first bracket personal tax rate to 5.05%, as well as sizeable cuts to the manufacturing and processing, general and small business tax rates. The effects of the reform will only start to be felt in the next fiscal year, however, as most initiatives will become effective July 1, 2010.

Total DBRS-adjusted expenditures are projected to rise by 15.0% in 2009-10 relative to the prior year’s estimates, primarily reflecting sharply higher capital spending. In an effort to stimulate economic activity and create jobs in Ontario, the Province is proposing to spend a total of $27.5 billion on infrastructure initiatives over the next two fiscal years alone. This compares to an annual average of roughly $8 billion recorded in the last four fiscal years, with all sectors showing strong increases. Notable increases are also budgeted in most program envelopes, including growth of 4.5% and 8.1% for health care and education, respectively. DBRS notes that the budget does not include any provision for potential assistance to the beleaguered auto industry, which is still being negotiated. However, a reserve of $1.2 billion included in each year of the three-year fiscal outlook, as well as operating and capital contingency funds totaling $3.4 billion for 2009-10, help mitigate expense risks.

The budget assumes a contraction in real GDP of -2.5% in 2009, followed by a rebound of 2.3% in 2010 and 3.3% in 2011. The assumption for 2009 is consistent with the private sector consensus, although views vary widely among forecasters, ranging from -1.2% to -3.3%. Due to the importance of its manufacturing sector, especially its auto industry, Ontario has been particularly hard hit by the downturn. As of February, the provincial unemployment rate reached 8.7%, a level not seen since April 1997, with Ontario leading all provinces with a total of 106,000 jobs lost during the first two months of the year. As such, the outlook carries significant downside risk, especially with respect to the rebound foreseen in 2010. Based on provincial estimates, a 1% shortfall in real GDP growth would translate into a $725 million revenue loss.

Based on preliminary results, total DBRS-adjusted debt should end 2008-09 up 10.1% year-over-year to $168.6 billion, or 28.3% of GDP. While higher than expected at the time of the last rating review in May 2008, the ratio still compares favorably with that of most other provinces. However, repeated deficits will considerably boost Ontario’s already large borrowing needs and squeeze financial flexibility over the years to come. Debt is projected to jump by $17 billion to $24 billion per year (8% to 14%) over the next three years, pushing the debt-to-GDP ratio up as high as 37% by 2012, a level unmatched since the mid-1990s, when the Province was grappling with serious fiscal problems. DBRS views such a burden as potentially manageable within the current AA rating, but notes that the unusually high downside risk carried in economic and fiscal projections may result in a debt burden markedly higher than forecasted and potential downward pressure on the rating.

This commentary constitutes a preliminary assessment of the Ontario budget, and will be followed by a formal in-depth review of the Province and the publication of a full report on the credit over the next three to four weeks.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Rating Canadian Provincial Governments, which can be found on our website under Methodologies.

This is a Corporate (Public Finance) rating.