Mathieu Frigon and Édison Roy-César
Economics, Resources and International Affairs Division
Canada’s currency union
The International Monetary Fund defines a currency union or a monetary union as an agreement among members – for example, provinces in Canada or countries in the eurozone – to share a common currency and a single monetary and foreign exchange policy.
Canada’s modern currency union began with Confederation in 1867, when the government of the new Dominion was given jurisdiction over currency and banking under the British North America Act.
Under a federal system, a currency union raises the issue of the borrowing cost of the central authority compared with the borrowing costs of members of the federation. There is also the issue of differences in borrowing costs among members of the federation.
In Canada’s case, yields, or the cost of borrowing, on 10-year bonds usually differ significantly between the federal government and the 10 provincial governments. However, differences in yields among provincial governments are relatively small in spite of their highly varying levels of indebtedness.
For example, on 31 March 2013, the ratio of net debt–to–gross domestic product (GDP) was at 48.7% for Quebec and -3.6% for Alberta. The negative ratio signifies that the value of Alberta’s financial assets was higher than that of its gross debt.
That said, the same month, the yield on Quebec’s 10-year bonds was 3.08% compared with 2.81% for Alberta, a difference of only 0.27 percentage point.
Figure 1 presents the evolution of the yields on the 10-year bonds of the federal government and the 10 provincial governments from 2009 to 2014. Figure 2 shows the net debt–to–GDP ratio and the 10-year bond yields of the 10 provincial governments on 31 March 2013.
Figure 1 – Federal and Provincial Governments 10-Year Bond Yields,
Figure 2 – Net Debt–to–Gross Domestic Product Ratio and 10-Year Bond Yields of the Provincial Governments, Canada, as of 31 March 2013
Source: Figure prepared by the authors using data obtained from Department of Finance Canada, Fiscal Reference Tables October 2013; Statistics Canada, “Table 384-0038, Gross domestic product, expenditure-based, provincial and territorial, annual (dollars x 1,000,000),” CANSIM (database), accessed 29 January 2015; and Bloomberg, accessed 29 January 2015.
Eurozone’s currency union
The eurozone is a monetary union of 19 European Union (EU) countries that have adopted the euro as their currency. Members are Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain.
The cost of borrowing varies widely among the eurozone members. As shown in Figure 3, in March 2013, yields on the 10-year bonds of eurozone members varied from as low as 1.35% for Germany, which had a net debt–to–GDP ratio of 56.1%, to as high as 11.38% for Greece, which had a net debt–to–GDP ratio of 169.7%.
Figure 3 – Net Debt–to–Gross Domestic Product Ratio and 10-Year Bond Yields of Seven Eurozone Members, March 2013
Source: Figure prepared by the authors using data obtained from the European Central Bank, Long-term interest rate statistics for EU Member States; and International Monetary Fund, World Economic Outlook Database, October 2014, accessed 4 March 2015.
The situation in the eurozone’s currency union contrasts with that in Canada’s currency union. While there are important government net debt–to–GDP ratio differences among members in both unions, in the eurozone – unlike in Canada – these differences are generally reflected in the yields of the eurozone members’ government bonds.
Key differences between the currency unions
One could ask why the results are so different for the Canadian provinces and the seven selected members of the eurozone.
A literature review and an analysis of the legislative and institutional monetary arrangement in Canada help identify four key factors that are either partially or completely absent in the eurozone:
- precedents for support from the central government;
- fiscal arrangements;
- a banking union; and
- formal lender-of-last-resort legislative framework.
Support from the central government
In Canada’s currency union history, federal intervention has helped provincial governments that were struggling financially. In the 1930s, for example, the federal government provided support for four provincial governments: British Columbia, Alberta, Saskatchewan and Manitoba.
The Great Depression of the 1930s undermined public finances in these four provinces, and some bondholders experienced significant delays before recovering their money. Nonetheless, all the private bondholders ultimately received the principal and interest payments due to them, thanks to the federal government assistance.
In fact, the only creditor that sustained a loss was the federal government, which wrote off parts of the loans it provided to the four provinces:
In fiscal year 1938, the Dominion wrote off $18 million [$291 million in 2015 dollars] of the Saskatchewan loan, but outstanding balances continued to grow – reaching $157 million in aggregate by the early 1940s. In 1947, [the Dominion] Parliament passed The Western Provinces Treasury Bills and Natural Resources Settlement Act which wrote off $55 million [$705 million in 2015 dollars] of the exposure and gave the four Provinces 30 years to pay off the remainder. In 1977, the loan balances finally disappeared from Canada’s public accounts. Since a portion of each province’s loan was written off by the 1947 Act, it is fair to say that all four provinces defaulted on a portion of their Depression-era debt.
In contrast to Canada’s currency union, where provincial private bondholders ultimately recovered the amounts due to them, in the eurozone, a precedent was created when Greece defaulted on its bonds and restructured its debt in 2012.
In a 29 January 2014 speech on the economics of currency unions, Mark Carney, previous governor of the Bank of Canada and now Governor of the Bank of England, said that effective currency unions tend to have centralized fiscal authorities whose spending is a sizeable share of GDP.
In Canada, federal government spending as a percentage of GDP was 14.7% in 2013–2014. In comparison, there is no central fiscal authority specifically for eurozone countries; the European Commission represents all 28 member countries of the EU, which includes nine countries that are not part of the eurozone. Furthermore, the European Commission budget stands at about 1% of the GDP of the 28 EU countries.
Canada’s currency union also has three main mechanisms to transfer income from the federal government to provincial governments: the Canada Health Transfer, the Canada Social Transfer, and Equalization.
These transfers, which totalled $61.4 billion in 2014–2015, are provided to provinces on the basis of formulas that are spelled out in the Federal–Provincial Fiscal Arrangements Act. Furthermore, there is a constitutional underpinning for the equalization program, as section 36(2) of the Constitution Act, 1982 states:
Parliament and the government of Canada are committed to the principle of making equalization payments to ensure that provincial governments have sufficient revenues to provide reasonably comparable levels of public services at reasonably comparable levels of taxation.
In his January 2014 speech, Mr. Carney said that effective currency unions need a wide range of instruments to support an integrated and efficient financial sector. These are often referred to as “banking unions” and notably include the following two elements:
- common supervisory standards; and
- a credible deposit guarantee scheme.
In Canada, it is the federal government that supervises and regulates commercial banks; it does so through the Office of the Superintendent of Financial Institutions. (Some financial institutions, such as credit unions, can be regulated by provincial governments; deposit insurance in these institutions is also provided provincially.) Similarly, the federal government guarantees deposits in commercial banks through one of its Crown corporations, the Canada Deposit Insurance Corporation.
In the eurozone, deposits in commercial banks are guaranteed by each member state. Moreover, prior to the financial crisis of 2008–2009, while directives and their implementation measures were decided at the EU level, competence for financial supervision and implementation remained with EU member states regulators. Starting in 2014, the Single Supervisory Mechanism, in which eurozone states are required to participate, granted the European Central Bank a supervisory role to monitor the financial stability of the largest banks in the eurozone, while the eurozone member state regulators continue to monitor the remaining banks.
Lender of last resort legislative framework
It is often said that the Government of Canada can never possibly run out of Canadian dollars, as its banker is the Bank of Canada, a Crown corporation fully owned by the federal government itself. The Bank of Canada, in turn, has the power and operational ability to create Canadian-dollar liquidity in unlimited amounts at any time. (This power is exercised within the Bank’s commitment to keep inflation low, stable and predictable.)
18. The Bank may …
(i) make loans or advances for periods not exceeding six months to the Government of Canada or the government of a province on taking security in readily marketable securities issued or guaranteed by Canada or any province;
(j) make loans to the Government of Canada or the government of any province, but such loans outstanding at any one time shall not, in the case of the Government of Canada, exceed one-third of the estimated revenue of the Government of Canada for its fiscal year, and shall not, in the case of a provincial government, exceed one-fourth of that government’s estimated revenue for its fiscal year, and such loans shall be repaid before the end of the first quarter after the end of the fiscal year of the government that has contracted the loan.
Thus, the Bank of Canada is a lender of last resort to provinces in an almost identical way as it is to the federal government. The only difference is the maximum amount of a loan under section 18(j).
In addition, section 18(j) stipulates that loans have to be repaid in the short term, that is, before the end of the first quarter after the end of the government’s fiscal year. However, since there is no clause forbidding loans renewal, it would appear that continuously rolling over the short-term loan to make it de facto repayable in the longer term is a possibility.
The eurozone has no such formal legal framework allowing member states to access a lender-of-last-resort facility at the European Central Bank. Therefore, in contrast to the situation in Canada, eurozone member states are more vulnerable to running out of money, and consequently, have higher default risk.
Summary: Four distinguishing factors of Canada’s currency union
Four factors differentiate Canada’s currency union from that of the eurozone. They are:
- historical precedents of support from the central government;
- fiscal arrangements;
- a banking union; and
- a formal lender-of-last-resort legislative framework.
Because of these factors, all provinces can be considered de facto to have relatively the same risk of default, irrespective of their net debt–to–GDP ratio, capacity to raise taxes, ability to reduce expenses, political weight in the federation, or any other factors that would normally play a role in assessing the risk of default of an entity.
Relatively similar default risks across provinces, in turn, mean relatively similar borrowing costs.
The partial or complete absence of these factors in the eurozone is one of the reasons that its currency union is perceived by the bond market to be riskier than Canada’s.
Hanniman, Kyle. Calm counsel: Fiscal federalism and provincial credit risk. Mowat Centre, 6 February 2015.
Joffe, Marc. Provincial Solvency and Federal Obligations. Macdonald-Laurier Institute, October 2012.