BUSINESS

INTERESTING TIMES

UPWARD PRESSURE ON FOREIGN LENDING COSTS THREATENS TO PUSH CANADIAN RATES HIGHER

JOHN DALY March 5 1990
BUSINESS

INTERESTING TIMES

UPWARD PRESSURE ON FOREIGN LENDING COSTS THREATENS TO PUSH CANADIAN RATES HIGHER

JOHN DALY March 5 1990

INTERESTING TIMES

BUSINESS

UPWARD PRESSURE ON FOREIGN LENDING COSTS THREATENS TO PUSH CANADIAN RATES HIGHER

The opposition attack on Finance Minister Michael Wilson’s budget was partisan, vitriolic—and predictable. But as Wilson defended himself in the House of Commons last week, the daunting prospect of higher interest rates in Japan, Europe and the United States sent chills through the finance department and loomed as a far more serious threat to Wilson’s economic strategy—and Canada’s economic future— than any domestic political fight. If foreign rates continue their relentless climb, Canadian rates will be pulled along in step to keep foreign investment flowing into Canada. But economists warn that another round of interest-rate hikes could bring Canada’s slowing economy to a standstill and derail Ottawa’s deficit-reduction program, perhaps forcing the finance minister to table another budget this fall. Said Carl Beigie, the widely respected chief economist with the Toronto-based brokerage firm McLean McCarthy Ltd.: “Canada cannot call the shots on interest rates—we have to follow the trends.”

And the trend towards higher rates in Japan and West Germany—the secondand thirdmost-powerful economies in the world—grew

more ominous last week. In Tokyo, the Nikkei stock market index plummeted by 2,569.35 points to 34,890.97—losing 6.9 per cent of its value in one week—largely in response to investors’ fears that the state Bank of Japan will soon be forced to renew its battle against inflation by raising its trendsetting interest rate for the fourth time in the past year. Last December, the bank raised the rate by half a percentage point to 4.25 per cent, up from just 2.5 per cent last May. In West Germany, longterm bond interest rates have climbed by more

than a percentage point to 8.8 per cent since January, their highest level in eight years. And economists predict that the looming merger of the West and East German economies will require massive amounts of new capital, which could fuel inflation and propel West German rates even higher.

As well, last week’s report that the U.S. inflation rate for January had increased by 1.1 per cent, the biggest one-month increase since June, 1982, again raised the spectre of higher American interest rates to cool inflation. The New York Stock Exchange declined, but not as precipitously as the Nikkei. The Dow Jones industrial average closed the week at 2564.19, down 71.4 points from the week before. Earlier, Alan Greenspan, the chairman of the Federal Reserve Board, calmed fears by telling a congressional committee that increases in U.S. interest rates are not warranted.

The Bank of Canada also attempted to quiet alarm over the trend to higher rates by fractionally lowering its trendsetting rate last week to 13.25 per cent from 13.32 per cent. For his part, Wilson in his budget confidently projected that short-term interest rates would fall even lower—to an average of 11.1 per cent by the

end of this year, from their current level of more than 13 per cent. He is desperately counting on those reductions to lower the cost of interest payments on Canada’s $351-billion national debt and allow him to hold this year’s federal budgetary deficit at $28.5 billion. And although he added a warning about inflation, Wilson confidently predicted that Canada will still be able to reduce rates even if rising inflation in Japan, Germany and the United States prompts central bankers in those countries to raise their rates. Said Wilson: “We still have a good deal of room to manoeuvre, provided we get our inflation down.”

But many powerful foreign investors and currency traders clearly do not share Wilson’s optimistic interest-rate projections. Michael Andrews, a vice-president and international bond strategist with the New York City-based investment firm Merrill Lynch & Co., said that those investors are nervous about Canada’s inflation rate, which, at 5.5 per cent, is almost double West Germany’s and Japan’s. As well, they are bothered by Canada’s slowing economic-growth rate, which is expected to drop

to 1.8 per cent this year from about three per cent in 1989, and the chronic federal budgetary deficit, which—expressed on a per capita basis—is 64 per cent larger than the $ 164.8billion shortfall in the United States.

To meet the government’s objective of a steady flow of foreign investment, Andrews said that Bank of Canada governor John Crow must ensure that the difference between Canadian commercial rates and equivalent rates in the United States—which currently is more than four percentage points—does not narrow. Said Andrews: “The Canadian dollar has lousy economic fundamentals behind it. The only thing that is supporting it is the interest-rate spread.”

Meanwhile, Canada’s dependence on foreign borrowing continues to mushroom. Since

1985, the proportion held by foreigners of federal government securities, such as Treasury bills and bonds, has almost doubled to 20 per cent, or $58.3 billion. The result: Canada is increasingly dependent on the whims of outsiders to finance its onerous national debt.

Increasingly, the competition for international financing facing the Canadian government is linked to events in West Germany and Japan. Said George Saba, chief economist of Montreal Trustco: “If there is a move towards German integration, that is going to siphon away capital that would otherwise be moving to the United States and Canada.” At the same time, events in Japan are also putting upward pressure on Canadian interest rates. Last week, as the Nikkei tumbled, the Bank of Japan attempted to halt the panic selling by stepping in and buying government securities, and by announcing that it had no immediate plans to raise interest rates. But many investors believe that Japan’s central bank will have no choice but to raise rates to quell the country’s rising inflation rate. Last year, the rate jumped to 2.8 per cent, compared with 0.8 per cent in 1988. But as rates rise in Japan, investors there—who now hold $20 billion worth of Canadian bonds and Treasury bills—may find their domestic market more attractive and secure than Canada’s.

As the storm clouds swirled around global financial markets, Greenspan attempted to downplay the impact of rising rates around the world. In cautious testimony before the Senate, Greenspan said that the increases were being spurred by Eastern Europe’s need for new investment. But he added that “unless something fundamentally new occurs, I’m not that concerned that rates will continue up.” Still, Greenspan said the worst of the current U.S. economic slowdown may be over, and that a resurgence of inflation is his main concern—a signal that he intends to battle inflation with high interest rates.

SOURCE: THE BANK OF CANADA

Despite Greenspan’s soothing words about the U.S. economy, he may be forced to raise those rates soon. Like Canada, the United States is a major debtor country and must use high interest rates to attract foreign investors. Said Surinder Suri, chief economist for London Life Insurance Co.: “There is only so much money available and so many people wanting it. The United States is a borrower on the international markets and so are we, and you don’t get money unless you are willing to pay higher interest rates.” And that was precisely the warning that international markets were sending Canada’s finance minister last week.

JOHN DALY with DAVID TODD in Toronto and DAVID LINDORFF in New York

DAVID TODD

DAVID LINDORFF