Worries about Quebec’s future and financial turmoil abroad drive markets into a tailspin

JOHN DALY July 1 1994


Worries about Quebec’s future and financial turmoil abroad drive markets into a tailspin

JOHN DALY July 1 1994



Worries about Quebec’s future and financial turmoil abroad drive markets into a tailspin

Peter Plaut is so enthusiastic about Canada’s economic prospects that he makes even Prime Minister Jean Chrétien sound like a pessimist. Plaut, 27, is the senior bond analyst in charge of Canada for Salomon Brothers Inc., the huge New York City-based securities dealer. And last week, while traders in Toronto and other world financial capitals panicked over a sharp jump in Canadian interest rates and wild swings in the value of the Canadian dollar, the view from Plaut’s office in Salomon’s headquarters in Manhattan’s World Trade Center remained astonishingly rosy. ‘We’re bullish on Canada,” said Plaut. He argues that Canadian economic growth remains robust, the provinces are slashing their budget deficits, Ottawa is getting set to follow suit and, if history is any guide, the growing anxiety among investors about Quebec’s future is bound to blow over.

“Past periods of political uncertainty have provided tremendous buying opportunities,” said Plaut. Coming from a firm that sells tens of millions of dollars worth of federal and provincial government bonds to U.S. and other foreign investors every year, that assessment could be overly optimistic.

But Plaut reeled off dozens of statistics to back up his argument. Declared Plaut:

“These wide gaps between Canadian and U.S. rates just aren’t justified by the fundamentals.” Plaut’s logic may be sound, but last week he was clearly in a minority in the world of high finance. As Chrétien and Parti Québécois (PQ) Leader Jacques Parizeau and Bloc Québécois Leader Lucien Bouchard continued to hurl insults at one another, Canadian


stock prices plunged and the dollar was besieged by international currency speculators. To defend the dollar, the Bank of Canada raised its trend-setting rate by a hefty 0.67 percentage points to 7.09 per cent. Banks and other financial institutions then quickly increased their loan rates, pushing the cost of a five-year closed mortgage up by a full percentage point to 10.75 per cent, three percentage points higher than the 7.75-per-cent rate that prevailed as recently as mid-March. Many economists say that those rate increases threaten to choke off a fragile economic recovery and make it impossible for Finance Minister Paul Martin to meet his $39.7 billion federal budget deficit target for the 1994-1995 fiscal year, which began on April 1. As well, the Bank of Canada will almost certainly have to raise rates again soon in response to a widely expected increase in American rates by the U.S. Federal Reserve Board sometime in the next few weeks.

Publicly at least, Chrétien said that the turmoil in the markets is solely the fault of Parizeau and Bouchard. Speaking to the House of Commons, Chrétien argued that with Statistics Canada recording a deflation rate of 0.2 per cent in May, employment growing and the economy expanding at a 4.2-per-cent annual rate in the first quarter, Canadians should now be reaping the benefits of that growth with cheaper credit. He added that the cure for higher rates is for Quebecers to choose Premier Daniel Johnson’s Liberals over the PQ in the Quebec election that must take place by November. “If Johnson were to win the election, interest rates will go down,” Chrétien said. “If Parizeau wins the election, unfortunately we will have to pay a bigger price.” Parizeau and Bouchard scoffed at those arguments, insisting that the Chrétien government’s inability to contain its own budget deficit, as well as worldwide financial instability, are to blame for the weakness of the dollar and the interest rate jumps. “The last increase of the interest rate is clearly exclusively motivated by international factors,” Bouchard told reporters. Parizeau, in turn, repeated his accusation that Canadian bankers and other financiers are trying to frighten Quebecers into voting Liberal. “Some Canadian financial institutions are trying to play politics with our own money,” said Parizeau. “Fair enough, but we don’t have to believe them.”

Behind the scenes, Martin and his officials were scrambling to assess the damage from the latest rate hikes. Since March, most interest rates have climbed about two percentage points higher than Martin forecast in his February 22 budget. If rates were to remain a percentage point higher than forecast for a full year, it would add $1.7 billion to the government’s borrowing costs—and to the deficit. Martin included $2.4 billion in spending in his estimates for unforseen contingencies.

Last week, Reform party Leader Preston Manning repeated his call for Martin to table a mini-budget, and Parliament Hill abounded with speculation that Martin was preparing just such a document, or a series of deep, new spending cuts, to meet his deficit target.

But in an interview with Maclean’s, Martin dismissed that speculation.

“People talk about how interest rates throw off the projections on the negative,” Martin said. “But what they also want to talk about is how the growth rate and the unemployment rate are substantially better than we

projected.” Martin added:

“This idea of having a minibudget is nuts. That’s a quote. It’s nuts. The implication is that you simply proceed from crisis to crisis as opposed to saying, look, that’s our goal and every effort of government is directed to that goal and there’s nothing that is going to cause us to deviate from it.”

Martin could afford to sound cocky last week because at least some of the pressure from abroad eased. A $2 billion issue of 7.75-per-cent, five-year government of Canada bonds sold out almost immediately the day that the bonds were issued. Whatever their fears about Quebec’s future, at least some investors clearly feel that higher yields on Canadian government bonds—which last week were holding about two percentage points higher than the yields on equivalent U.S. government bonds—are more than enough to compensate them for the additional risk. As well, the controversy about Quebec blunted Manning’s attacks and those of other critics who blame high interest rates on the deficit and the national debt.


Liberal Claude Ryan helps convince Quebecers to say No to sovereignty talks on May 20,1980

Still, most economists and other experts concede that external developments have added to the upward pressure on interest rates and the downward pressure on the dollar and stock prices. Last week, the U.S. dollar dipped briefly to 99.95 Japanese yen, a postwar low, before steadying to close the week at 100.41 yen. That sparked widespread speculation that the U.S. Federal Reserve Board chairman will increase U.S. interest rates soon. Alan Greenspan has been nudging U.S. rates up since February, in part to defend the beleaguered greenback, but also to contain inflationary pressures in the U.S. economy, which has bounced back from the recession far faster than Canada’s. If Greenspan raises rates again, Bank of Canada governor Gordon Thiessen will have little choice other than to follow suit.

Those adverse external pressures set the current crisis apart from previous


I Canada rejects the Charlottetown constitutional agreement on Oct. 26,1992

bouts of anxiety over Quebec’s future. There was similar turbulence in the financial markets—in 1976 when the PQ got elected for the first time, during the lead-up to the province’s 1980 referendum on sovereignty association and during the 1992 national referendum campaign on the Charlottetown constitutional accord. But in those instances, developments in the United States were not exerting such a drag on the Canadian economy.

In each of those previous instances, the dollar and financial markets steadied or rebounded fairly quickly after the crisis passed. Heading towards a fall Quebec election, most economists predict that rates will continue to rise and the dollar will continue to weaken.

But the experts are sharply divided on what will occur after the election if the PQ maintains its current lead in the polls and wins. One bond trader with a foreign-owned investment dealer, who declined to be identified because his firm conducts a lot of business with Ottawa, said that a PQ win “will crush the economy and you’ll have a Canadian dollar at 67 cents.” He added that foreign bond buyers may then swoop in in search of bargains. “It’s going to negatively affect the economy, which is positive for the bond ghouls,” said the trader.

Salomon Brothers’ Plaut is advising his clients—predominantly U.S., European and Japanese pension fund managers and other large institutional investors—to consider buying even sooner. Plaut said that the two-percentage-point gap between yields on longterm Quebec government bonds denominated in U.S. dollars and U.S. government bonds is approaching its highest level in three years. “We believe that no matter who wins the election, bond prices will rise,” he said. His reasoning: the uncertainty over the result will have passed, and even if the PQ wins, polls show that most Quebecers still oppose independence. Plaut added: “When I speak to my clients, they say, ‘It’s not that I don’t want to invest in Canada, it’s just a question of timing.’ ”

Despite Plaut’s enthusiasm, for the moment at least, most of those institutional investors—both in Canada and abroad—appear to be waiting on the sidelines until the storm passes.