GLOBAL MARKETS IN TURMOIL : Canada: Up North, a Struggle With Fiscal Demons

While world attention focuses on Mexico’s peso crisis, Canada--the United States’ other partner in the North American Free Trade Agreement--is struggling with its own economic demons.

Continuing a yearlong slide, the Canadian dollar on Thursday hit 70.55 cents, a nine-year low against the American currency, before rallying slightly on Friday. Banks, looking to protect the Canadian dollar, raised interest rates. The prime rate moved to a two-year high of 8.5% and mortgage rates climbed.

That bodes ill for Canada’s continued economic recovery.

Housing sales, for example, plummeted 21.2% in December contrasted with the previous year.

Against this backdrop, analysts agreed Friday that the greatest tests for Canada’s currency lie ahead. Before it is over, the Canadian dollar could drop below its all-time low of 69.2 cents, set in February, 1986.

Underlying the dollar decline here is investor unrest over Canada’s huge public debt, proportionally among the largest of developed nations, and the political uncertainty presented by a separatist government in Quebec. Those two issues will dominate Canada’s political and economic agenda for at least the first half of the year.

In February, Prime Minister Jean Chretien will present a new budget, and financial markets will be watching to see if he and Finance Minister Paul Martin live up to promises to significantly dent the government deficit.

“Foreign investors as well as domestic investors will be looking forward to the budget here. It will be a watershed event for the financial markets,” said Robert Palombi, an economist with MMS International, a Toronto consulting firm.

The government has been laying the groundwork for budget cuts in social programs dear to Canadians. Among other things, tax-supported programs pay for health care for all, maintain low college-tuition fees, provide generous unemployment and welfare benefits and subsidize businesses ranging from dairy farming to motion picture production.

Defenders of this generosity say it is one reason Canadian cities generally are safer, cleaner and have less poverty than their American counterparts. But these programs have increasingly been financed with borrowed money. The combined debt of Canada’s federal government and the 10 provinces totals about $500 billion, equal to the gross domestic product. About 40% of the debt is financed by foreign investors, making the dollar even more sensitive to quirks of the international marketplace.

Analysts say investors are also wary that Martin’s new budget deficit reduction plan may rely too heavily on tax increases rather than spending cuts. “This is a critical budget for Canada. Expectations are very high,” said Patti Croft, senior economist for the investment firm Wood Gundy. “If there is too much reliance on tax increases, it will not fly with the markets. Canada already is pretty heavily taxed.”

The current expectation is that there should be at least $5 of spending cuts for every $1 of tax increases, analysts said. A higher tax ratio would encourage expansion of the underground economy and drive investment out of the country. But all bets may be off in June if voters in Quebec endorse “sovereignty” for the mainly French-speaking province. An affirmative vote could lead to a unilateral declaration of independence by the separatist party that governs Quebec.

A report by the C. D. Howe Institute, a Toronto think tank, this week said a unilateral declaration of independence by Quebec could prompt economic flight from Canada and bring on the country’s worst financial crisis since the Great Depression. Voter surveys in Quebec continue to show a majority oppose independence from Canada, but the latest poll, published Monday, reported a rise in support for sovereignty to 47%. That may have contributed to investor aversion to the Canadian dollar.

Chretien complains that the country’s economic good news is too often overlooked. Canada has near zero inflation and is expected to show 4.2% economic growth in 1994. Unemployment is 9.6%, but is down from the double digits rates of recent years.