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 Canadian economy suffered a massive contraction in the first half of the year due to the Coronavirus (Covid-19) outbreak and associated restrictions. Output declined 13.4% from the fourth quarter of 2019 to the second quarter of 2020. However, the economy hit bottom in April and a strong recovery is now under way. High frequency activity indicators point to a robust rebound in the third quarter. In the last four months, the labor market has recovered nearly two-thirds of the jobs lost in March and April. Moreover, the housing market has held up remarkably well. According to the OECD’s Economic Outlook September 2020, Canada’s GDP is expected to decline 5.8% in 2020 and then expand 4.0% in 2021. Notwithstanding some encouraging signs related to the recovery, the outlook is still highly uncertain and will likely depend on the evolution of the virus.
The recovery is being supported by extraordinary levels of fiscal and monetary stimulus. The federal government’s last projection in July pointed to a deficit of 15.9% of GDP in FY20-21. The magnitude of this shock does present some challenges for Canadian public finances. In particular, public debt levels will be substantially higher in the aftermath of the COVID-19 shock, which could limit policy flexibility in the future. However, these credit challenges are offset by Canada's considerable fundamental strengths, including its sound macroeconomic policy frameworks, large and diverse economy, and strong governing institutions. In our view, the federal government has space to provide temporary fiscal stimulus of this size while maintaining the AAA ratings.
The main risks to the ratings would come from either a sustained deterioration in fiscal policy discipline over the medium term, or weaker growth prospects. If the ongoing recovery stalls, our concerns would intensify about potentially longer-lasting damage to the economy. The longer the duration of the shock, the greater the risk of prolonged high unemployment and low investment, both of which could weaken medium-term growth prospects. The resulting damage to the economy's productive capacity could lead to more persistent pressures on balance sheets across the economy, including government finances.
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 if there is a weakened commitment to fiscal sustainability.
Canada Has Space to Provide Temporary Fiscal Stimulus While Maintaining the AAA Ratings
The fiscal deficit is set to reach a record high this year. In its July 8th Fiscal Snapshot, the federal government projected that the deficit would widen to $343 billion (15.9% of GDP) in FY20-21, up from $34 billion (1.5%) the prior year. The increase in the deficit is driven by automatic stabilizers as well as discretionary stimulus measures. Pandemic-related emergency policy actions are expected to increase the deficit by $228 billion (10.6% of GDP). The two largest programs are the Canada Employment Response Benefit (CERB) and the Canada Emergency Wage Subsidy (CEWS). Additional spending measures have been announced since the Snapshot, although these costs will likely be offset to some degree by a lower-than-planned uptake on several stimulus programs, particularly the CEWS. DBRS Morningstar views the overall fiscal response positively, as the stimulus has been timely in delivery, temporary in design, and sufficient in size given the scale of the shock.
The government has not provided fiscal projections beyond FY20-21, but the Speech from the Throne on September 23rd and a fiscal update or budget in the fall should provide greater detail on the administration’s legislative agenda. We will be focused on the medium-term sustainability, counter-cyclicality, and growth-enhancing features of the multi-year fiscal strategy. The government has already outlined a temporary plan to reduce qualification criteria for employment insurance and create several parallel schemes for workers that do not qualify. This would come into effect as the CERB expires at the end of September. The post-CERB income support plan, which still requires parliamentary approval, is projected to cost about $29 billion (1.3% of GDP) over two fiscal years.
The massive fiscal deficit combined with the deep recession will lead to higher government debt levels. The IMF projected in June that debt-to-GDP for the general government (i.e. federal plus provincial plus municipal governments) would increase from 89% in 2019 to 109% in 2020, although the projected 2020 ratio will probably underestimate the final result as additional fiscal measures were announced following the projection. Notwithstanding the level increase, several factors support the outlook for public finances. First, the pandemic-related fiscal measures announced so far are temporary. This could change as the government lays out its economic agenda in the coming weeks, but emergency programs such as CEWS and CERB are designed to expire. Second, Canadian public finances entered the crisis from a strong starting position. The government had space to absorb a temporary shock and even accommodate some permanent deterioration without undermining debt sustainability. Third, government borrowing costs are very low. The nominal yield on 10-year government bonds averaged just 0.6% over the last six months. As a result, debt servicing costs remain quite affordable despite the higher level of debt.
In addition, the general government’s balance sheet was in relatively good shape going into 2020. Although the public debt ratio was high last year, the ratio was closer to the average of other highly-rated peers if you exclude accounts payable, which improves comparability across countries. Furthermore, pensions in Canada are largely funded, which adds to the government’s explicit debt burden today but puts the public sector in a comparatively strong position to manage pension costs in the future. 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 A Smooth Functioning of Markets
The Bank of Canada cut the policy rate by 150 basis points in March to 0.25% and launched a large scale asset purchase program to support the recovery. The monetary policy stance will likely remain highly expansionary for a few years, as central bank authorities have stated their commitment to keep rates low and continue quantitative easing until the recovery is well underway. In addition, the central bank expanded liquidity facilities and introduced a large number of emergency lending programs in order to put financial markets on surer footing and ensure that monetary policy was being transmitted to various corners of the market. These stabilization measures have been effective. Following the shock to markets in late March, financial conditions improved, with credit spreads narrowing across a variety of markets and equity prices rebounding.
The Covid-19 shock has adversely impacted bank earnings and asset quality, but the Canadian banking system is well-positioned to weather the pandemic. Banks have posted elevated loan impairments, largely related to sectors directly affected by the shock, particularly oil and gas, retail, and hospitality. Moreover, outstanding loans covered by payment deferrals at the six large Canadian banks amounted to $264 billion, or 8.5% of aggregate gross loans, in the third quarter. While banks have responded by significantly increasing loan loss provisioning, the six large banks benefit from strong balance sheets and diversified earnings capacity to absorb a higher level of credit losses. Several factors also point to resilience in the banks’ domestic mortgage portfolios. Mortgage insurance rules and lending standards have been incrementally tightened over the last decade, which will help contain risks of deteriorating asset quality. Furthermore, thirty-eight percent of outstanding mortgage balances were insured at origination or through portfolio insurance obtained by these banks. Of those mortgages that are uninsured, the loan-to-value ratios are below 80%, which provides banks with greater protection in the event of a housing price shock. 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. While lower interest rates and ongoing income support programs should support household spending in the near term, the high stock of debt could act as a headwind to growth over time by forcing some borrowers to pull back on consumption and investment. Low-income households and younger worker appear particularly vulnerable given that they have bared the brunt of the job losses and typically have less savings set aside.
The housing market has so far shown resilience during the pandemic. Housing starts, sales, and prices have all surpassed pre-pandemic highs. The sharp rebound in demand at least partly reflects pent-up demand following the shutdown in April and early May. The outlook for the housing market will balance the dampening demand effects of a soft labor market and reduced immigration, with the supportive impulse coming from low mortgage rates and ongoing supply constraints. In some cities, housing affordability concerns could intensify.
Federal Elections Are Possible But Not Likely Following Prime Minister’s Throne Speech
Prime Minister Trudeau prorogued Parliament in mid-August and announced his intention to lay out the government’s legislative agenda in the Speech from the Throne, which is scheduled for September 23rd. Opposition parties will have the opportunity to trigger elections with a non-confidence vote following the Throne Speech. However, it is not clear that the opposition parties would benefit from another election given the current polling, which suggests that the Liberal Party would win the most seats if not an outright majority. The Liberal Party formed a minority government after winning a plurality of seats in the October 2019 federal election. Without a majority, the Liberals must seek out partners on a case-by-case basis to pass legislation.
Canada’s strong governing institutions are a key strength of the credit profile. Canada is a stable liberal democracy with sound policy 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 Shock
The Canadian economy is expected to expand at a moderate pace over the medium term once the effects of the pandemic recede. Prior to the shock, 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. Other structural factors also appear to be impeding higher growth. Over the last three decades, Canada’s labor productivity performance has lagged other advanced economies. In addition, the pandemic carries downside risks to the medium-term growth outlook, as the shock could have scarring effects that adversely affect employment and investment.
Canada’s external accounts do not exhibit any clear vulnerabilities. Exchange rate flexibility helps the economy adjust to evolving global conditions. The current account deficit narrowed to 1.9% of GDP in the second quarter of 2020 (rolling 4 quarters) on the back of softer import demand. Notwithstanding consistent current account deficits over the last decade, 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.
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/366966.
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 https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments (July 27, 2020)
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 March 27, 2020.
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: NO
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
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