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TORONTO (Reuters) - Ontario is losing the confidence of many of the investors it counts on to fund its budget deficit and could face damaging credit market downgrades unless it can convince the market that it's serious about curbing spending.
But the minority government of Canada's most populous province may find it hard to play the austerity game, as both spending cuts and tax hikes risk alienating voters.
Ontario's finances are under scrutiny after a former senior federal official - who once helped Ottawa tame its budget deficit - warned that without change, the province could eventually spin into a European-style crisis.
Former bank economist Don Drummond last week issued a series of almost 400 recommendations, urging Ontario to cap total spending growth at levels unprecedented in Canadian postwar history.
Yet market players warn the harsh medicine is necessary if the province, one of the world's biggest non-sovereign borrowers, is to regain their trust.
"It's going to take a lot of confidence building before we go back to market weight or overweight," Hosen Marjaee, senior managing director at Manulife Asset Management, said of Ontario bonds.
Marjaee, who has been underweight the province's debt for almost a year, added: "We would reduce our exposure even further if we realize that there is no light at the end of the tunnel."
The global recession left manufacturing-heavy Ontario with a debt-to-GDP ratio of almost 40 percent, which is among the highest of Canada's provinces. Its C$16 billion shortfall is Canada's biggest and the government projects it will be eliminated only by 2017-18.
Ontario's 10-year bond yield is about 84 basis points above the Canadian government counterpart's 2022 bonds.
While this has dropped from 99 basis points in November as fears about Europe's debt crisis eased, analysts noted the spread was below 40 before the last recession.
Marjaee said a widening of spreads by another 10 basis points might present a buying opportunity.
Ontario is not expected to adopt all Drummond's ideas. But investors and rating agencies are looking for more detail than usual in a budget due this spring, along with a realistic gameplan that reflects downsized growth and revenue forecasts.
"It seems as though they've just hoped to delay and pray for sunnier days and that things will improve and that they'll be able to grow out of their problems ... but to this date that situation hasn't presented itself," said Brian Calder, a bond trader at Bissett Investment Management in Calgary, who is also underweight Ontario bonds.
Ontario's credit ratings are AA- at S&P, Aa1 negative at Moody's and AA low at DBRS. They are investment grade ratings, but one to three notches below the federal government's top rating. DBRS and Standard & Poor's downgraded Ontario debt in 2009, and Moody's gave the province a negative outlook in December.
Sheryl King, head of Canadian economics at Bank of America-Merrill Lynch, said the risk of a rating downgrade for Ontario has risen, which could cause the spread against Canadian debt to widen further, increasing its borrowing costs.
"(Drummond) will carry a lot of weight with the rating agencies. They will be looking at this and doing maybe a more deep dive and saying, 'Are the government's budget assumptions really feasible?'" said King.
So far, ratings agencies are watching rather than acting.
In a response to Drummond's "somewhat bleak" report, DBRS reminded its clients that the Ontario government's strategy continues to be vague.
Eric Beauchemin, managing director of public finance at DBRS, said in an interview the longer Ontario takes to provide clarity, the more worried the agency will become and the more likely it is that the province will have to raise taxes, breaking an election promise.
"We believe there is some flexibility within the current rating and the challenge again can be overcome, but they will have to get really aggressive on the measures," he said.
Not every money manager is bearish on Ontario. Some have bulked up on the province's bonds, betting Drummond's stern warnings and debate about the need for austerity will spur the Liberal government into tough action.
"The one thing that I do like about Ontario is that to a certain extent, when their back is up against the wall, when they need to make the changes that need to be made, they do them, they take the necessary steps," said Claudio Ferri, senior fixed income portfolio manager at State Street Global Advisors in Montreal, who is overweight Ontario bonds.
He said asset managers chasing higher returns are attracted to provincial credit, which often serves as a proxy for Canada's relatively small corporate credit market.
That said, he warned traders should have stop-losses in place in case the situation quickly worsens.
"If the view is wrong then you need to step out as fast as you can and the Canadian provincial bond market is liquid enough that it can allow you a way out," said Ferri.
Editing by Janet Guttsman and Jeffrey Hodgson