Difficult choices to improve a vulnerable financial situation
The Province of N&L faces an unprecedented fiscal situation. The two main ingredients that led to today’s dire financial situation are: 1-the rapid pace of increase in program spending that occurred prior to the oil shock; and 2-the slide in crude oil prices observed since late 2014. The provincial Liberal government, elected in late November of last year, mentioned in mid-December that the Province of N&L couldn’t continue down that slippery road. Under the status quo, the Province confronts the prospect of annual deficits near $2B for the next five years and a net debt-to-NGDP ratio ballooning above 60% – a figure not seen in any Canadian provinces since the darker days of the early 1990s.
For investors to fully understand the gravity of the situation for this small province of 528K people, the $2.2B deficit estimate for FY 2015-16 is $1.1B above budget. It also represents 7.3% of NGDP, not far from the 10% deficit-to-NGDP ratio figure registered by the U.S. Federal government in 2009 during the financial crisis. Given this track record, the credit agency S&P did not hesitated long before downgrading the long-term province credit rating, from A+ to A with a negative outlook in late January. The new Premier Dwight Ball and the new Finance Minister Cathy Bennett understand that the status quo was not an option. This is why their first budget delivered in St John’s on April 14th includes difficult decisions which needed to be made immediately in order to give a chance to the Province to get back on track financially.
Immediate actions required
To begin with, an exhaustive line-by-line review of all expenditure items was undertaken in recent months, leading to the delivery of a large-scale restructuring effort including the elimination of public sector jobs through attrition and early retirement incentives, cuts in subsidies and class sizes, the closure of government offices, etc.
Measures on the revenue side of the ledger are also austere: an average household will be paying nearly $3K more in taxes and fees per year; a massive drag on disposable income (Statistics Canada estimates the median total income of a N&L family at about $74K). The budget contains several tax increases, including a 2% hike in the HST from 13% to 15%. The biggest surprise is the introduction of a new deficit reduction levy that will cost taxpayers up to $900 annually depending on the taxable income of the individuals (both will come into effect on July 1st).
Two points need to be made here before we go further. The increase in the tax burden announced is undeniably a major negative shock to absorb for Newfoundlanders. But, from a fiscal standpoint, the objective is to rely more on stable sources of revenues rather than on relatively unpredictable oil royalties (expected to account for only 7% of total fiscal revenues this year, compared to 30% just a few years ago). This is, a positive development that should catch both credit agencies’ and investors’ attention.
Also, the 2016 budget needs to be viewed in a broader perspective. The current budget represents the first of three phases that will include all measures necessary to bring back a balanced budget in 2021-22 (implying 9 straight years of deficits that began back in FY 2012-13). The second phase, a mini-budget, will be presented next fall. The final step will be the 2017 budget. The media have reported the privatization of the Newfoundland Liquor Corporation among the possible options on the table. Indeed, asset sales to generate one-time revenues and lower the debt burden, or other unconventional initiatives, could eventually be in order to narrow the large fiscal gap.
Oil Outlook
This being said, it isn’t the time to speculate on the government’s future actions since they will largely depend on what will happen with oil prices. In other words, even if oil royalties will count for less than before as a share of total revenues, the fiscal outlook still remain highly dependent on the Brent oil price outlook (the N&L offshore oil industry receives Brent prices for its oil). At the time the provincial Liberals were preparing their first budget, the oil outlook was still very much uncertain. For instance, the global oil market could move closer to (or further) from balance, depending on whether participants at this weekend’s OPEC meeting in Doha agree or not to freeze their crude production going forward. Naturally, uncertainty led the N&L government to use prudent assumptions: Brent crude oil prices are projected to increase mildly in the medium-term from US$40 per barrel in FY 2016-17 to US$60 in FY 2018-19 before hovering near US$70 beyond that. The LBS Economic Research and Strategy team projects that the new equilibrium price will be higher-than-budgeted by the N&L Ministry of Finance, especially during the next two years. Beyond the imminent OPEC meeting outcome in Quatar, our rationale is based on the forthcoming reduction in non-OPEC output (especially U.S. oil shale production), stronger demand (especially during the US summer driving season going through April to September), and eventual production cut by OPEC and Russia. In our view, the combined impact of these factors will clear excess global oil inventories more rapidly than anticipated by the consensus. As a result, we forecast WTI (and Brent) prices to end 2016 at US$68 per barrel and to average US$75 in 2017.
Conclusion
In summary, the Province’s fiscal situation is undeniably one of the most fragile we’ve seen during this budget season. For instance, it unusual for a province to spend more money on debt servicing (12 cents out of every dollar spend this year) than on education, the result of a debt-to-NGDP ratio already popping above 40%. The good news is that the new government rapidly decided to take actions since taking office last November. Without the countless tax and spending cut initiatives announced in this budget, the debt would be sky-high. In her budget speech, Finance Minister Cathy Bennett said “The net debt as of March 31, 2023 will be targeted to be $16.5 billion, compared to $27.3 billion if we did not take definitive actions; Borrowing targets that over the seven year period will require $8.2 billion in new debt, compared to $17.6 billion if nothing had changed” (The Province forecasts borrow requirements at $3.4B this year).
As we mentioned just above, investors will need to closely monitor coming developments on the global oil markets to evaluate the situation. Yet, there is another source of uncertainty which weighs on N&L: the release of a new report to be delivered by end of May will present a new schedule and costing for Muskrat Falls, the hydroelectricity generating facility that is currently being constructed on the Labrador Lower Churchill River. On that front, the Finance Minister said the “Muskrat Falls powerhouse is significantly behind schedule. Faced with these schedule delays and expected cost increases on the project… government is doing and will continue to do everything possible to help get this project back on track”. Concretely, this means that the size of the revision to budgetary costs could alter the Province’s fiscal outlook and its debt issuance plan.
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