Here's why Ottawa has a moral obligation to save N.L. from the fiscal cliff

Newfoundland and Labrador is at a crossroads.

Despite finding itself in its most dire financial situation since the depression, this issue has largely been ignored in the current federal election.

Within two years, the taxpayers of Newfoundland will have to start paying interest on the Muskrat Falls debt — both the $8 billion financed by the federal government and the $4 billion financed by the province itself. This bill will be approximately $750 million a year, and will last for generations.

Under the original design for the project, this bill was to be paid by ratepayers. That is, anyone who currently pays a hydro bill.

In order to cover this bill, electricity prices will have to double. This will have a ruinous effect on the quality of life in Newfoundland, where almost half of electricity is used for heating.

A future of rising bills and prices

As consumers struggle with these costs, businesses will have no choice but to increase prices, and municipalities will increase taxes to cover their own bills. Those on fixed income will suffer the most, and young people are already voting with their feet: hundreds are leaving the province every month.

Premier Dwight Ball has said that ratepayers cannot be expected to cover these costs, and the bill will be assumed by the province itself. His government has also proposed solutions for rate mitigation; however, all of them depend on non-existent and questionable revenue sources.

Currently, N.L. borrows hundreds of millions a year to make up the gap between what we make on taxes and what we actually spend.

Without a miracle, trying to pay this new bill leaves the province with three choices:

1. Borrow another $700 million a year to pay this bill.

2. Double electricity rates.

3. Increase taxes to the tune of hundreds of millions of dollars a year.

Each move risks plunging the province into a brutal fiscal trap.

The bond rating agencies have warned N.L. that it cannot continue to finance public services with heavy borrowing. Just days ago, Finance Minister Tom Osborne said he cannot ask taxpayers for either more taxes or more cutbacks in services. Given that the bond raters have put the province on warning, the minister's announcement puts the province on a dangerous collision course with financial catastrophe.

No option but to keep borrowing

Newfoundland and Labrador currently owes the world's bankers approximately $17.9 billion, with more being borrowed every day.

The interest on this debt alone is a significant cost for taxpayers, and absorbs a billion dollars a year. That's more than what's spent on education and many other vital services. Ball's promise to cover Nalcor's Muskrat Falls debt means another $9.4 billion will be added to the province's total, an incredible $27.3 billion.

In effect, every person in N.L. now owes the bond markets $52,000 — and the province has no option other than to keep borrowing, and keep adding to this horrendous total.

The current ratio of debt to gross domestic product for N.L. is just over 30 per cent, which is considered high for a small province, but still bearable.

The province cannot solve this problem alone. It has neither the economic strength nor the tax capacity to fix this.

When the Nalcor debt is added to the province's ongoing bill, this ratio will more than double, to 81.5 per cent.

The people who fund Newfoundland and Labrador's annual deficits have already warned the province that this situation is not sustainable, yet neither the federal nor the provincial government has done anything concrete to slow this headlong plunge into insolvency.

The young people of this province are not stupid — they're already moving away in droves, and the fear and uncertainty of the province's fiscal situation is only going to hasten this exodus.

The province cannot solve this problem alone. It has neither the economic strength nor the tax capacity to fix this.

It has two realistic options to avoid a plunge into bankruptcy.

First, is the Dignity Option, in which the federal government supports the province, and eases the financial strain which is hamstringing Newfoundland and Labrador.

The second is the Nuclear Option: default.

What the Nuclear Option would mean

The government of Canada helped this province finance $8 billion of the Muskrat Falls debt. This was done through two things called the Muskrat Falls/Labrador Transmission Assets Funding Trust and Labrador-Island Link Funding Trust. The sole purpose was to borrow the $8 billion and lend them to the project.

Canada guarantees the principal and interest, however N.L., through the issuer, has given guarantee assurance agreements with Canada to assure that it is ultimately responsible for both the interest and principal. However, N.L. is functionally insolvent with no capacity to raise taxes, so where will it get the revenue to cover these payments?

Newfoundland and Labrador can only double power rates, and watch 520,000 people freeze in the dark, or vastly hike taxes and destroy the economy.

The premier has already turned down both options.

The province has another choice: the Nuclear Option. It can voluntarily default on its interest payments. N.L. can declare to its bondholders and the federal government that the province is insolvent and can no longer pay its debts.

This course would have two immediate effects.

First, it would reduce the province's further borrowing options to almost nothing, and force immediate cutbacks in the province's services, many of which are currently paid for on borrowed money.

Our debts would immediately become non-investment grade, in the BB or lower class, if not in the default category. Currently, N.L. needs $1 billion to finance its structural deficit, and another billion for infrastructure expenditure for highways, schools, hospitals and payments for existing debts.

The province needs a good credit rating to finance this $2 billion, something that will evaporate if it defaults.

More important for the country as a whole, however, is that an N.L. default would rock the Canadian financial system to its foundations.

Newfoundland and Labrador is not the only province carrying heavy debts, or borrowing money to cover daily spending. Interest rates for these provincial debts are currently relatively low, because the bond raters assume that the federal government won't let any provincial government go bankrupt.

A default by the province will damage every province's rates, and as costs soar, all the weaker provinces will feel the pain. The federal government is also running large deficits, and such a shock would increase its own costs.

Let's revisit the Dignity Option

Canada cannot afford to have N.L. slide into insolvency or default on its debts. The Dignity Option would see Canada providing the province with an additional $1.4 billion a year until the year 2041, a sum which would both ease N.L.'s current fiscal straitjacket, and also help right a historical wrong.

Much of N.L.'s current financial straits date back to the events of the late 1960s, when the government of Newfoundland was trying to negotiate a power corridor through Quebec, in order to deliver hydro power from the nascent Churchill Falls development to markets in the northeast U.S.

Although this power corridor was Newfoundland's right under the British North America Act, and the Smallwood government had prepared letters asking for this corridor, it was not to be. Fearing a separatist backlash in Quebec, the federal government under Lester Pearson persuaded Newfoundland not to press for its rights.

At the least, this corridor would have allowed N.L. to negotiate a fair price for Churchill Falls electricity.

Instead it was forced to sell its power to Hydro-Quebec at $2.50 to 2.95 per megawatt-hour, which that utility was able to sell at $60 per megawatt-hour, making immense profits.

In effect, N.L. took a massive financial hit for the Canadian Confederation.

The federal government has both the fiscal capacity — and the moral obligation — to solve this problem, and to restore this province to health.

This is a historical wrong which the federal government can now repair.

The Dignity Option involves Canada paying N.L. an appropriate rate of three cents a kilowatt-hour for the 30 billion kilowatt-hours of Churchill Falls power that Newfoundland and Labrador is compelled to sell to Hydro-Quebec — or $900 million annually — for the duration of the Churchill Falls contract. That's 2041.

Second, Canada should pay the interest on the $8 billion of federally guaranteed Muskrat Falls debt, plus the interest on the $4 billion in equity financing that N.L. put into Muskrat Falls: $500 million in annual interest.

The $900 million electricity payment plus $500 million in interest on Muskrat Falls debt would equal $1.4 billion, and would be paid annually over 22 years.

After 2041, when the Churchill Falls deal expires, N.L. can regain control over its power sales and would take over paying the interest on the total Muskrat interest, plus the principal of the $8 billion of federal debt on Muskrat Falls.

Remember: N.L. does not receive equalization

Despite its financial woes, Newfoundland and Labrador currently receives nothing from the federal equalization program.

This new payment of $1.4 billion would raise the federal contribution of annual revenue from Ottawa approximately to 32 per cent of provincial revenue — which is only in line with what the other three Atlantic provinces are already receiving.

Given that N.L. is the weakest of the Atlantic provinces, this is at best equitable treatment for the province.

The Dignity Option saves Canada having to repay the $8 billion in principal on the Muskrat guaranteed debt.

The dignity method will cost Canada $31 billion over the next 20 years. However, it will save $8 billion of its own Muskrat Falls debt, which will be repaid by N.L. after 2041. In other words, the full cost of restoring the province's dignity and financial sanity is $23 billion.

Meanwhile, ignoring the situation will eventually force N.L. into default, and trigger a fiscal crisis that will shake the whole country.

Can provinces actually fail?

Newfoundland and Labrador is not the only province that has found itself in such dire straits, and there is precedent for this federal intervention.

Many observers will say that it is impossible for provinces to fail — but this is not the case.

Saskatchewan came very close to insolvency in 1993. It experienced the same bond rating cuts that threaten N.L., and suddenly the province could no longer finance maturing debt, or borrow any further to fund its deficit.

Painted into a corner, it closed 52 hospitals and slashed funding to all other public services.

The province went cap in hand to Ottawa, where the NDP government of Roy Romanow received $1 billion. After more severe cuts to public services and many tax hikes, Saskatchewan was able to survive, and eventually return to prosperity.

N.L. needs over $8 billion a year to pay for public services, as well as the interest on our current debts. Taxes and other revenue bring in approximately $6.2 billion.

The shortfall is being made up by one method: borrowing. The provincial government has said it cannot cut services, and so its only recourse is to borrow more money to make up the shortfall. The Muskrat Falls payments will require an additional $700 million a year.

No one knows where that money is coming from, but we do know this — the world's lenders and bankers are watching this province with a very cold eye.

Newfoundland and Labrador needs $1.4 billion a year until 2041 to pay its debts and restore its economic health.

The federal government has both the fiscal capacity — and the moral obligation — to solve this problem, and to restore this province to health.

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