Canada's finances are in better shape than those of the rest of the Group of Seven...and capital is flowing into the country, all of which means that "there are opportunities which, in our opinion, should be taken advantage of."
Mark Carney, Governor, Bank of Canada*
It’s almost impossible to open a newspaper today without reading something about the debt crisis in Europe.
It sometimes feels like there is a new European country announcing debt issues that threaten the global economy each day.
But what does all this mean to you and the rest of us Canadians?
Let’s begin at the beginning.
Simply put, sovereign debt is the debt a government takes on to function and provide basic services. Countries, provinces/states, and even municipalities issue bonds to build and maintain roads, hospitals, etc., and must pay a certain amount of interest to bondholders who buy this debt. Bondholders buy debt to receive interest payments on their bond investments, and with the assumption that the bond issuer will be able to pay back their debt through tax and other forms of revenue.
While there is significant complexity to this crisis and its roots go back many years, the severity of the global economic downturn we have experienced these past few years has exposed tremendous weakness in many European countries. Recognizing that the following is a simplification of the problem, it is clear that the level of debt has risen in relation to cash inflows. This is a result of both the accumulation of deficits and debt over several years compounded by the need for bailouts at the same time that tax revenues were decreasing sharply due to a weaker global economy.
With record levels of debt, the concern is now the possibility of a default, meaning one of these countries – possibly a very large one like Italy or Spain – will be unable to repay its debt, sending major shock waves through the global economy.
Why would a default cause such a shock to the global economy? Because so much of the debt out there is held by governments, banks, and other large and small investors. A default could result in significant write-downs and losses.
Thankfully Canada has been largely shielded from Europe’s debt issues, in that our government and banks have not been large holders of the debt of countries that are currently facing debt issues.
This means a lower risk of significant write-downs than many other European bondholders.
That said, there are still areas in which Canadians would feel the impact of a default. European banks are large holders of Europe’s sovereign debt, and investing in these banks, as many Canadian financial institutions do, may cause some valuation weakness.
Canada’s relatively low amount of debt and large materials sector, however, should position us well when the global economy once again picks up. And, our country’s strong banking system should continue to underpin a relatively strong amount of growth for our economy.
*Source: The Globe and Mail, Carney calls on businesses to step up, Jeremy Torobin and Tavia Grant, December 12, 2011. Photo Source: CTVnews.com
