DBRS Confirms Government of Canada at AAA Stable

DBRS Inc. has confirmed the Government of Canada’s Long-Term Foreign and Local Currency – Issuer Ratings at AAA and Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high). The trend on all ratings is Stable. The AAA ratings are underpinned by Canada’s large and diverse economy, prudent macroeconomic policymaking, and strong public institutions.

The economic recovery in Canada has recently accelerated and become more broad-based. The near-term growth outlook is positive, supported by robust foreign demand and strengthening business confidence. Fiscal and monetary policies are expected to gradually tighten as the output gap closes and inflationary pressures pick up. However, uncertainty over U.S. trade and tax policies pose risks to the outlook, and domestic imbalances remain a source of concern. High levels of household debt leave the economy vulnerable to employment and interest rate shocks. In addition, house prices in the Toronto and Vancouver areas appear well above levels consistent with economic fundamentals and, therefore, could be subject to a correction.

The AAA ratings are supported by Canada’s strong public finances and sound fiscal management. While gross general government debt is high at 92% of GDP, the government balance sheet benefits from substantial financial assets. On a net basis, Canada’s public debt burden amounted to 27% of GDP in 2016, which compares favorably to most highly-rated peers. Moreover, public debt ratios are expected to decline over the next five years as fiscal accounts gradually improve and the economy grows at a moderate pace. With a strong public balance sheet and substantial financing flexibility, Canada has fiscal space to provide temporary support to the economy if downside risks materialize without putting stress on the ratings.

The cyclical recovery in Canada is well-advanced. In the first seven months of 2017, the economy expanded 3.4% year-over-year, with contributions coming from resource industries, non-resource goods industries, and services industries. Employment growth has stabilized in resource-based provinces and accelerated in non-resource-based provinces. In terms of capital, non-residential business investment remains weak following large cutbacks in 2015 and 2016, but there are early signs of a recovery. Taken together, recent data suggests that the drag from the oil-price shock in 2014 has largely passed and that slack in the economy is quickly diminishing. The IMF projects GDP growth of 3.0% in 2017 and 2.1% in 2018.

Fiscal and monetary policies are expected to gradually tighten as spare capacity in the economy diminishes. Since the oil-price shock three years ago, the government has provided a modest countercyclical fiscal stimulus, which DBRS viewed as prudent and well-timed. However, with the cyclical recovery now entrenched, fiscal policy is expected to move to a more neutral stance next year and then begin to tighten.

The Bank of Canada has already started to withdraw extraordinary monetary stimulus. The target for the overnight rate was increased 25 basis points in July and again in September, taking the rate to 1.0%. The pace of monetary tightening will likely depend on the evolution of economic activity and ongoing assessments of the output gap, which is subject to some uncertainty. Although growth has recently accelerated, the Bank of Canada’s three preferred core inflation measures remain below the 2.0% target.

Risks to the economic outlook in the near term largely stem from the external environment. Protectionist measures by the United States, potentially including an outright withdrawal from NAFTA, could have an impact on the competitiveness of North American firms and lead to gradual changes in cross-border production chains. Greater impediments to trade – tariff or non-tariff – would likely reduce Canada’s potential growth. In addition, unanticipated shocks to the global economy, such as a sharp deceleration in China, could affect Canada through deteriorating terms of trade, weaker global demand, and financial market volatility. Finally, interest rates in Canada could rise faster than expected if U.S. growth accelerates, potentially on the back of the proposed tax cuts.

The key domestic vulnerability in Canada is high household debt. In the second quarter of 2017, household debt as a share of disposable income reached a record high 170%. If a negative growth shock were to materialize, high debt could amplify the shock by forcing borrowers, particularly those with limited savings, to pull back on consumption. Adverse wealth effects stemming from a correction in house prices could intensify the shock. At the same time, financing conditions could tighten as Canadian banks face increased credit costs and weaker collateral values.

A correction in house prices in Toronto and Vancouver in isolation, however, is not likely to cause significant macroeconomic disruption. In both cities, robust employment growth and steady population gains underpin housing demand. Moreover, the run-up in house prices has not been accompanied by clear evidence of a misallocation of labor and capital. Though a price correction could generate adverse wealth effects in these two cities and the surrounding areas, the effects on the broader economy and financial system would likely be manageable.

RATING DRIVERS
The Stable trend reflects DBRS’s view that Canada has a high capacity to absorb shocks and cope with pending challenges. The ratings could experience downward pressure in the medium term, however, if a large shock were to significantly weaken growth prospects and fiscal outcomes, resulting in a sustained deterioration in public debt dynamics and policy credibility.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales. These can be found at http://www.dbrs.com/about/methodologies.

The sources of information used for this rating include the Department of Finance, Bank of Canada, Statistics Canada, IMF, UNDP, World Economic Forum, The Conference Board Total Economy Database-May 2017, Federal Reserve Bank of Dallas, The Canadian Real Estate Association, JPMorgan, and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating was not initiated at the request of the rated entity.

The rated entity or its related entities did participate in the rating process. DBRS did not have access to the accounts and other relevant internal documents of the rated entity or its related entities.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

Lead Analyst: Michael Heydt, Vice President, Global Sovereign Ratings
Rating Committee Chair: Alan G. Reid, Group Managing Director, Financial Institutions and Sovereign Groups
Initial Rating Date: October 16, 1987
Last Rating Date: November 25, 2016

Information regarding DBRS ratings, including definitions, policies and methodologies, is available on www.dbrs.com.