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 Government of Canada’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS

The spread of Coronavirus Disease (COVID-19) and the collapse in oil prices pose a clear downside risk to Canada’s growth outlook. Prior to the outbreak, overall economic conditions in Canada were relatively strong. The economy was operating close to potential. The unemployment rate was near its lowest level in over forty years and inflation was hovering around the Bank of Canada’s 2% target. Several temporary shocks negatively affected activity in the fourth quarter of 2019 and the first quarter of 2020, but our expectation was for the economy to recover as these headwinds faded.

With the coronavirus outbreak and the sharp fall in oil prices, Canada’s near-term growth outlook has markedly deteriorated. Measures to contain the virus include the shutdown of most non-essential businesses across much of the country. At the same time, Canadian oil producers are being adversely affected by the combination of softer global demand and increased production. The price of West Texas Intermediate (WTI) is down over 60% since the start of the year, and Western Canada Select (WCS) has fallen below the $10/bbl level. The deteriorating outlook has fed through to the equity prices, which have also experienced large declines. At a minimum, the confluence of these shocks will have a severe negative impact on economic activity in the first half of the year. If the shocks prove to be short-lived (i.e. 1-2 quarters), markets may recover quickly and the economic damage may be moderate.

However, the magnitude and duration of these shocks is highly uncertain. Output losses could be substantially greater if the containment measures implemented to curb the virus’s spread disrupt daily life longer than anticipated and global commodity prices remain low for longer. Reduced levels of investment, workdays lost to sickness or childcare, and prolonged restrictions on leisure activities could temporarily impact the economy’s productive capacity. On the demand side, weaker terms of trade, sharply lower business sentiment, and a softer labor market could negatively affect consumption and investment. While some sectors might be able to recover the lost output as demand returns, other parts of the economy could experience more long-lasting damage.

Notwithstanding the deep recessionary outlook in the near term, Canada has substantial capacity to absorb shocks and cope with pending challenges without putting downward pressure on the ratings. The credit profile is underpinned by Canada’s large and diverse economy, prudent macroeconomic policymaking, and strong governing institutions. Moreover, the government is responding to the public health crisis and accompanying economic fallout with coordinated fiscal, monetary, and regulatory policy actions. The emergency response will likely be scaled up in the coming weeks. While the public health crisis will need to subside for a recovery to firmly take hold, large and timely stimulus should lessen the damage stemming from the sudden stop in commercial activity and then accelerate the recovery by reinforcing pent-up demand as the virus-containment measures ease.

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 be downgraded in the medium term if there is a sustained deterioration in public debt dynamics and policy credibility.

RATING RATIONALE

A Strong Public Balance Sheet Gives The Federal Government Ample Space To Deliver Fiscal Stimulus

The federal government has announced “phase one” of a stimulus plan to mitigate the economic damage caused by the coronavirus pandemic. Direct stimulus measures announced thus far amount to CAD 27 billion (1.2% of GDP). More than half is in the form of cash payments to individuals who cannot work due to COVID-19 or are unemployed and do not qualify for employment insurance. Another CAD 7 billion in assistance will go to low- and middle-income families by topping up the GST tax credit and Canada Child Benefit. Importantly, the measures will provide one-off income support to vulnerable workers in the near term.

Another set of measures will support cashflow. The federal government is allowing individuals and businesses to postpone CAD 55 billion in tax payments (2.5% of GDP) until the end of August. While the tax deferral does not really constitute stimulus as the payment is just postponed 4 months, it could be an important source of liquidity. This was accompanied by a six-month interest-free moratorium on the repayment of Canada student loans and the announcement by Canadian banks that they would offer households experiencing financial hardship a six-month deferral on mortgage and other credit payments. The cashflow measures should help families and firms cover basic needs and meet financial obligations in the near term.

However, the fiscal package announced so far is relatively modest in size given the scale of the shock. Based on announced stimulus measures and an estimate of the automatic stabilizers, the federal deficit could widen from the previously projected baseline of CAD 28 billion (1.2% of GDP) to more than CAD 80 billion, or approximately 3.5% of GDP. However, Finance Minister Morneau has stated that more support will be forthcoming. In particular, the federal government is likely to provide substantially more relief to oil-producing provinces, as well as to specific sectors such as energy, airlines, and tourism. As a result, the federal deficit will likely end up being much larger.

Canada has ample space to provide temporary fiscal stimulus given the government’s long track record of sound budgetary management, substantial financing flexibility, and robust balance sheet. Canadian public finances are entering the crisis from a strong starting position. Prior to the virus outbreak , the fiscal outlook at a general government level was on a sustainable trajectory. Canada’s debt outlook is also supported by very low funding costs. The yield on 10-year government bonds averaged just 1.6% in 2019, which is slightly negative in real terms. During the more recent period of elevated global risk aversion, the yield has fallen to just 0.8%.

In addition, the public sector balance sheet is in relatively good shape. While gross general government debt is somewhat high at 88% of GDP, the debt ratio is closer to the average of other highly-rated peers if accounts payable is excluded, which improves comparability across countries. Moreover, Canada’s balance sheet benefits 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. These two factors account for the one category uplift in the “Debt and Liquidity” building block assessment.

The Bank Of Canada Is Acting Aggressively To Support The Economy And Ensure The Smooth Functioning of Markets

Over the last two weeks, the Bank of Canada has cut the policy rate by 100 bps to 0.75%. The central bank will likely ease further at its April 15th meeting, if not sooner, and has signaled it could introduce unconventional easing measures, such as forward guidance and quantitative easing. In order to maintain liquidity in the financial system and facilitate the transmission of the recent cuts, the central bank has unveiled a host of emergency liquidity facilities. These include introducing a Bankers Acceptance Purchase Facility, expanding the Government of Canada Bond Buyback Program and term repo operations, launching the new Standing Term Liquidity Facility, and establishing a Provincial Money Market Purchase program. The measures aim to alleviate liquidity and funding stress in the financial markets and help financial system adjust smoothly to a new and less favorable economic outlook.

In this challenging context, Canadian banks are likely to experience increased credit costs, particularly if the shocks prove to be long-lasting. DBRS Morningstar expects that even with liquidity-enhancing and credit-support measures, some firms and individuals will not be able to stay current on their financial obligations. However, several factors support the resilience of the financial system. Canadian banks are well-capitalized and in a strong liquidity position, which should help them manage market volatility and absorb greater provisioning, if necessary. Mortgage insurance rules and lending standards have also been incrementally tightened over the last decade, which will help contain risks of deteriorating asset quality. In addition, thirty-eight percent of the outstanding mortgage balance was insured at origination or through portfolio insurance. Of those mortgages that are uninsured, the loan-to-value ratios are below 80%, which provides banks with greater protection. Our assessment of the measures taken by authorities to reduce financial stability risks positively influences our “Monetary Policy and Financial Stability” building block assessment.

A key domestic vulnerability is high household indebtedness. Debt to disposable income increased from 108% in 2001 to 176% in 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, there is still a vulnerability related to the outstanding stock. The high level of household debt could amplify the current shocks by forcing some borrowers, particularly those with limited savings, to pull back on consumption and investment. Household deleveraging could end up dampening the recovery once virus-containment measures ease.

The COVID-19 pandemic has likely brought the housing market to a standstill but the longer term impact is not clear. Prior to the outbreak, the housing market was experiencing a recovery. Resale activity and prices in 2019 increased on the back of robust population growth, strong labor markets, and declining mortgage rates. In some parts of the country, robust demand amid limited supply was putting upward pressure on prices and intensifying housing affordability concerns, particularly in the greater Toronto and Vancouver areas. However, the coronavirus shock will likely put a freeze on the market. When conditions normalize, housing activity and price dynamics will depend, in large part, on the health of the labor market.

Canada Benefits from Strong Public Institutions

The Liberal Party, led by Justin Trudeau, formed a minority government after winning a plurality of seats in the October 2019 federal election. Without a majority, the Liberals need to seek out partners on a case-by-case basis to pass legislation. Opposition parties voted in support of the recent stimulus legislation, and the Liberals will likely find support for additional stimulus in the coming weeks and months.

Canada’s strong governing institutions are a key strength of the credit profile. Canada is a stable liberal democracy with sound public management. The country is characterized by strong rule of law, a robust 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.

Medium-Term Growth Outlook Could Depend On The Duration Of the Shocks

Once the shocks dissipate, the Canadian economy is expected to expand at a moderate pace over the medium term. Prior to the shocks, the IMF projected annual growth over the medium-term growth at 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 a rising share of the population moves out of the labor force and in to retirement. Structural factors also appear to be impeding higher growth. Canada’s labor productivity performance has lagged other advanced economies over the last three decades. However, medium-term growth could be even lower if the coronavirus or oil price shocks end up having a more lasting impact on investment.

Canada’s external accounts do not exhibit any clear imbalances. Exchange rate flexibility should help the economy adjust to evolving global conditions. The current account deficit narrowed to 2.0% of GDP in 2019 on the back of softer import demand. Notwithstanding consistent current account deficits over the last seven 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.

ESG CONSIDERATIONS

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/358928/.

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

The principal methodology is the Global Methodology for Rating Sovereign Governments (September 17, 2019): https://www.dbrsmorningstar.com/research/350410/.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

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 Morningstar 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 Morningstar 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 (DBRS Morningstar) 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 11, 2019.

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.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: YES

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 Morningstar 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, Senior 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 http://www.dbrsmorningstar.com.

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