In his latest Economic and Fiscal Update, Minister of Finance John Manley says that the budget surplus forecast in the February 2003 budget has been reduced to $2.3 billion in the 2003/04 fiscal year due to weaker growth and assorted shocks that hit the economy this year.

He also suggested that future surpluses will be smaller than expected: $3 billion in 2004/05, $3 billion in 2005/06, $4 billion in 2006/07, and $6 billion and $7 billion in the following two years.

The surplus, the seventh in a row, is smaller than expected, notes RBC Financial. Manley reported that it dipped to $2.3 billion in the 2003/04 fiscal year due to weaker growth and assorted shocks that hit the economy in 2003. He also suggested that future surpluses will be smaller than expected: $3 billion in 2004/05, $3 billion in 2005/06, $4 billion in 2006/07, and $6 billion and $7 billion in the following two years.

“At this early stage a few key points jump out. The Federal government has committed to transferring $2 billion of the $2.3 billon surplus to the provinces to help pay for this year’s unexpected jump in health care costs. Originally, the provinces were only to get this money if the Federal surplus topped $3 billion, but now the Feds are going to transfer the funds anyway,” RBC observes. “This leaves only $300 million earmarked for debt reduction, likely the smallest debt repayment since the surpluses began seven years ago.”

However, RBC also suggests that between now and the fall of 2004, when the books are finally closed on this fiscal year, there is a chance the surplus could be revised higher than $2.3 billion, “particularly as the effects of the surging U.S. economy feed through to Canada.”

BMO Nesbitt Burns notes that Manley has revised economic growth projections to 1.9% this year, 3.0% in 2004, and 3.2% in 2005. “These are very reasonable assumptions for growth, not far from our call of 2.0%, 3.0%, and 3.5% for the same three years,” it says. “The projections are also slightly more modest than what the Bank of Canada is calling for.”

“The incoming Prime Minister will have precious little room to manoeuvre, with the underlying surplus trimmed to just $2.3 billion this year and $3 billion in each of the next two years,” says Nesbitt. “Still, Canada’s fiscal position remains quite healthy compared to both the situation of just a few years ago and the rest of the G7. For example, Ottawa’s debt/GDP ratio is projected to fall from 44.2% now to 31.5% by FY08/09, not far from Paul Martin’s stated goal of 25% and miles away from the mid-90s peak of 68.4%.”

RBC also notes that the rather than the usual practice of projecting a $3 billion contingency reserve and a prudence factor that starts at $1 billion and rises with each succeeding year, the next two years have been presented without a prudence factor. “This means the surplus for the next two years is just $3 billion, and these contingency reserves go directly to debt reduction if not needed. The message: there are no extra funds new initiatives at this time. Fiscal belt-tightening is expected to be a key feature of the first years of Paul Martin’s mandate, unless the economy grows faster than currently anticipated,” RBC says. “Although there is a good chance of that, the stage is set for the running of a tight ship for at least the next year. This highlights another key message: unlike the U.S. Administration, Canadian officials remain committed to balanced budgets, fiscal restraint and prudent projections.”

Nesbitt suggests that the consistent fiscal performance by Ottawa is a key argument in favour of a further narrowing in long-term Canada/U.S. interest rate spreads. “If short-term rates narrow at all in the year ahead, as we suspect, the 10-year differential could test the zero line, down from around 55 basis points at present,” it says. “Ottawa has managed to stay in surplus with minimal spending restraint recently. While Mr. Manley pointed to a $1 billion in spending reallocation, program spending is now expected to rise 6.6% from last year’s level. A more complete review of spending priorities is likely under a new Prime Minister, which could yet free up room for other priorities (such as tax cuts).”