Filing the Debt Gap In Canada

The total amount of Canadian federal and provincial debt outstanding was just under C$900 billion ($643 billion) at the end of 1998, slightly under 100% of GDP. After decades of virtually uninterrupted rise, government indebtedness as a percentage of GDP has begun to decline in response to the much improved fiscal situation for both levels of government and positive economic growth.

The much improved fiscal situation in Canada is having a major impact on the federal government's borrowing requirements in financial markets. Between 1995 and 1997 interest rates across the yield curve fell sharply. Some of this decline can be attributed to increasing confidence in the Bank of Canada's ability to maintain low inflation. However, a large portion clearly reflects reduced risk premiums on Canadian dollar assets due to the determined efforts by governments to address long-standing fiscal concerns.

Let me now turn to the implications of reduced government borrowing for the functioning of financial markets. As a true central banker, let me deal first with some of the negative factors.

One is when investor demand broadly exceeds the amount outstanding, perhaps because investors are not able to acquire other instruments with similar investment characteristics. Another is when one or more market participants attempts to exert undue influence over the price of a specific security by acquiring a significant portion of the amount outstanding, and hoarding it in anticipation that they will profit as the yield on that security declines, commonly called "squeezes."

Keeping It Liquid

[Canada's] Department of Finance and the Bank of Canada have a special interest in ensuring that the market for federal government debt functions smoothly. A liquid and well-functioning government market provides a useful benchmark for the proper operation of other markets, like the corporate and the securitization markets.

In 1997, the frequency of Treasury bill auctions was reduced from a weekly to a bi-weekly schedule. This systematically bunched the supply of new bills to give market participants more of an opportunity to acquire bills at larger-sized auctions. Looking ahead, we will consider more restructuring of the Treasury bill and bond program as the need arises.

To address the risk that market participants could attempt to exert undue influence over individual issues of Canadian Treasurys, we have changed the rules for participation at auctions that also give the authorities the ability to better oversee the process. These proposals are designed to protect the integrity of the primary market by reducing the opportunity for market participants to manipulate auctions of new debt, thereby encouraging a broad distribution, and keeping the borrowing costs of the government as low as possible.

In addition, improvements have been made to strengthen the integrity of the secondary market. Recently, we participated in an initiative by the Investment Dealers' Association to introduce a code of conduct governing acceptable trading practices for Canadian debt markets.

Securitization At The Forefront

The combination of lower interest rates and less supply of government securities has led to the enhancement of the corporate market in Canada as well as the development of new products domestically, particularly products such as asset-backed securities.

One of the most interesting developments in recent years has been the development of the securitization market in Canada. Since the federal government is utilizing a smaller share of domestic savings, other borrowers are moving into the breach. These borrowers are essentially responding to investors' desire for spread product as they seek to limit the impact of lower interest rates on their portfolio returns.

In particular, securitization is filling the need of investors who are looking for high credit quality investments in the wake of reductions in government debt issuance. Indeed, prior to the onset of the Asia-induced market turmoil there were signs that asset-backed commercial paper in particular would rapidly overtake more traditional commercial paper issuance in Canada as investors, looking to enhance their return on capital, become more comfortable with the product.

These trends were interrupted, however, by the recent market turbulence in the fall of 1998, which coincided with the banks' fiscal year end. Credit spreads widened out in response to safe-haven flows as investors world-wide sought refuge in high-quality government debt instruments and U.S. dollar denominated assets in particular.

However, markets - including the securitization market - have since recovered. The result is a rapidly developing securitization market that has reached the C$50 billion ($36 billion) milestone in size, which ranks Canada about fifth in the world in terms of absolute size of the market. As with any developing market of course there are teething problems, particularly in the depth and liquidity of some segments of the market. These problems however should be lessened over time as the market grows.

This is an excerpt from a speech given at the Second Annual Asset Securitization Forum, held in Whistler, B.C. earlier this month.