DBRS Morningstar Confirms Government of Canada at AAA Stable

DBRS, Inc. (DBRS Morningstar) confirmed the Government of Canada’s Long-Term Foreign and Local Currency – Issuer Ratings at AAA. At the same time, DBRS Morningstar confirmed the Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS

The AAA ratings are underpinned by Canada’s large and diverse economy, prudent macroeconomic policymaking, and strong governing institutions. Overall economic conditions in Canada remain strong, despite the temporary slowdown at the start of the year. The unemployment rate is at its lowest level in over forty years and inflation is hovering around the Bank of Canada’s 2% target. DBRS Morningstar expects the economy to operate close to potential in 2020 and 2021. Housing markets are also stabilizing after earlier interest rate increases and tighter mortgage rules helped to cool the market and ease financial stability concerns. Federal parliamentary elections are scheduled for October 21st. Regardless of the outcome, DBRS Morningstar expects that sound macroeconomic policy will be sustained through the electoral cycle.

Notwithstanding the relatively benign baseline outlook, the Canadian economy faces a number of risks. A sharper-than-expected global slowdown, potentially aggravated by increasing protectionism, could soften demand for Canadian exports, reduce oil prices, and dampen business investment. On the domestic side, high levels of household debt leave the economy more vulnerable to employment and interest rate shocks.

RATING DRIVERS

The Stable Trend reflects DBRS Morningstar’s view that Canada has a high capacity to absorb shocks and cope with potential challenges. However, the ratings could experience downward pressure in the medium term 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.

RATING RATIONALE

Strong Public Finances Support the AAA Ratings

Canada has an increasingly long track record of sound budgetary management. Although most provinces face medium-term challenges related to rising healthcare costs, public finances at a general government level are sustainable. Fiscal policy has also been effective in terms of demand management. Expansionary policy supported the economy in the aftermath of the 2014 oil-price shock. However, policy has moved to a more neutral setting as spare capacity in the economy has diminished.

With a strong public sector balance sheet and substantial financing flexibility, Canada has space to provide temporary fiscal support to the economy if downside risks materialize. The IMF reports gross general government debt at 90% of GDP, which is relatively high. However, if accounts payable is excluded to improve comparability across countries, the ratio is 74%, which is slightly above the average of other highly-rated peers. Public finances also benefit from the low level of unfunded pension liabilities. The fact that public pension schemes in Canada are largely funded, unlike in many other advanced economies, puts the government in a comparatively strong position to manage rising pension costs as the population ages. In addition to sound fiscal management, the debt sustainability outlook is supported by very low funding costs. The yield on 10-year government bonds averaged just 1.6% in the first nine months of 2019, which is slightly negative in real terms.

Canada Benefits from Strong Public Institutions

Canada is a stable liberal democracy with effective public institutions. The country is characterized by strong rule of law, a sound regulatory environment, and low levels of corruption. According to the World Bank’s Worldwide Governance Indicators, Canada ranks highly compared to other advanced economies in all areas of measured governance.

DBRS Morningstar believes that sound macroeconomic policy will be sustained through the electoral cycle. Polls show a close race between the two leading parties. It is unclear whether any single party will win enough support to command a majority in parliament. Policy proposals by leading parties suggest that federal fiscal policy could turn modestly expansionary over the next few years and potentially provide some support to the near-term growth outlook. A modest rise in deficits is unlikely to have negative implications for the rating, although the quality of spending will be an important determinant of Canada’s medium-term growth prospects.

Potential Growth is Constrained by Ageing Demographics and Underperforming Labor Productivity

The Canadian economy is expected to expand at a moderate pace over the medium term. From 2020 to 2024, output is set to grow at an average annual rate of 1.7%. This is lower than Canada’s historical growth performance, although in line with the structural slowdown experienced across most advanced economies. Slower growth in Canada is partly due to ageing demographics, as the share of working age people relative to the population is declining. However, structural factors also appear to be impeding higher growth. Canada’s labor productivity performance has lagged other advanced economies over the last three decades.

Canada’s external accounts do not exhibit any clear imbalances. The current account deficit, at 2.6% of GDP in 2018, is expected to narrow slightly over the medium term as investment stabilizes and domestic savings gradually increase. Exchange rate flexibility should help the economy adjust to evolving global conditions. Notwithstanding consistent current account deficits over the last six years, Canada has shifted from a net international liability position to a net asset position, as external assets have benefited from buoyant global markets and local currency depreciation.

The Housing Market Has Cooled but High Household Debt Remains a Vulnerability

Higher interest rates and tighter mortgage qualification rules have had a salutary effect on the housing market. The Toronto and Vancouver area markets have cooled over the last two years, following several years of rapid price increases that fed overvaluation concerns. The adjustment has been orderly and markets now appear to be stabilizing. Resale activity has picked up in both markets, albeit at a more moderate level. Housing price declines have eased in the Vancouver area and prices are rising modestly in the Toronto area. Notwithstanding the soft landing, housing prices in both cities remain elevated. Given the strong demand, efforts to durably address affordability concerns will likely depend on efforts to increase supply.

The key domestic vulnerability is high household indebtedness. Debt to disposable income increased from 108% in 2001 to 176% in mid-2017. Over the last two years, however, the ratio leveled off as credit growth slowed. While the wave of household debt appears to be cresting, the vulnerability related to the high stock of debt will remain over the medium term. High household indebtedness could amplify negative shocks by forcing borrowers, particularly those with limited savings, to pull back on consumption and investment amid declining net wealth and tighter financing conditions.

An adverse shock in the context of high household indebtedness could lead to increased credit costs for Canadian banks, but several factors support the resilience of the financial system. Mortgage insurance rules and lending standards have been incrementally tightened over the last decade to contain risks of deteriorating asset quality. About 40% of the outstanding mortgage balance was insured at origination or through portfolio insurance. Those mortgages that are uninsured have loan-to-value ratios below 80%, which provides banks with greater protection. Furthermore, Canadian banks are well-capitalized and highly profitable, which puts them in a strong position to absorb greater provisioning related to home lending, if necessary.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments:
https://www.dbrs.com/research/351554/.

Notes:
All figures are in Canadian dollars unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS Morningstar website www.dbrs.com at http://www.dbrs.com/about/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 at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The primary sources of information used for this rating include Department of Finance, Bank of Canada, Statistics Canada, IMF, UN, World Bank, NRGI, Brookings, BIS, The Canadian Real Estate Association 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 for this rating action. DBRS did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

This rating is endorsed by DBRS Ratings Limited for use in the European Union. The following additional regulatory disclosures apply to endorsed ratings:

The last rating action on this issuer took place on October 12, 2018.

Solely with respect to ESMA regulations in the European Union, this is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer.

This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party

Generally, the conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are monitored.

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

Lead Analyst: Michael Heydt, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer – Global FIG and Sovereign Ratings
Initial Rating Date: October 16, 1987

For more information on this credit or on this industry, visit www.dbrs.com.

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