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
Canada’s AAA ratings are underpinned by the country’s considerable fundamental strengths, including its sound macroeconomic policy frameworks, large and diverse economy, and strong governing institutions. The Stable trend reflects our view that Canada’s credit profile remains strong despite the economic and health fallout from the pandemic.
The recovery of the Canadian economy looks set to continue as health conditions improve. GDP expanded by 9.6% q/q (annualized) in the fourth quarter of 2020 and preliminary data suggests that momentum was sustained into January, despite tighter social distancing restrictions in late 2020 and early 2021. The IMF projects GDP growth of 3.6% in 2021 and 4.1% in 2022. We think risks to this forecast are skewed to the upside. New COVID-19 cases have trended down since peaking in mid-January and vaccine distribution is expected to quicken over the next few months. Once the health crisis subsides, the recovery is primed to accelerate on the back of easing restrictions, highly accommodative macroeconomic policies, and consumers’ willingness to spend part of the excess savings accumulated in 2020. Higher commodity prices and strengthening external demand from the United States further support recovery prospects. Notwithstanding the improving outlook, extended delays in the vaccine rollout or the spread of more-contagious variants of the virus could delay the recovery in the near term.
The government is delivering an extraordinary level of fiscal and monetary support to head off economic scarring. The federal government projects a deficit of 17.5% of GDP in FY20-21. Once the virus is contained and the recovery firmly takes root, we expect the deficit to quickly decline as revenues rebound and emergency spending winds down. Overall, we view the fiscal response positively. Some public finance metrics have deteriorated due to scale of the fiscal support. Gross government debt-to-GDP is projected to increase nearly 30 percentage points from 2019 to 2021. However, Canadian public finances entered the pandemic in a strong position, and debt servicing costs are very low despite the higher level of debt.
The Stable trend reflects our view that a downgrade of the ratings is unlikely in the near term. Canada has considerable capacity to absorb shocks and cope with pending 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 emergency fiscal spending in response to the pandemic is massive in scale but temporary in design. The deficit is set to reach $382 billion (17.5% of GDP) in FY20/21, up from $34 billion (1.5%) the prior year. Overall, we think the size and design of the emergency fiscal support has helped – and will continue to help – mitigate the economic impact of the coronavirus shock on Canadian households and firms, and thereby put the economy in a stronger position to recover. As the pandemic passes, the baseline deficit is forecast to narrow to $121 billion (5.2% of GDP) in FY21/22, $51 billion (2.1%) in FY22/23, and $43 billion (1.7%) in FY23/24. On top of that baseline forecast, the federal government is putting together a $70-100 billion public investment plan. If executed, this would add roughly 1-2 percentage points of GDP to the baseline deficits in each of the next three years. The ultimate size, timing, and composition of the investment plan are still under consideration. We expect more information will be forthcoming in the 2021 Budget.
The large fiscal deficit in 2020 combined with the deep recession has led to markedly higher government debt. The IMF projected in January 2021 that debt-to-GDP for the general government (i.e. federal plus provincial plus municipal governments) will increase from 87% in 2019 to 116% in 2021. Notwithstanding the level increase, several factors support Canadian public finances. First, the pandemic-related fiscal measures announced are temporary. In particular, income support and wage subsidy programs will automatically decline as economic conditions improve. Second, Canadian fiscal accounts 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, even after taking into account the recent rise in longer term yields. The nominal yield on the 10-year government bond averaged 1.4% over the first two weeks of March. As a result, debt servicing costs remain quite affordable despite the higher level of debt.
In addition, the government balance sheet was in relatively good shape going into 2020. Although Canada’s gross debt-to-GDP is high, the ratio is approximately 18 percentage points lower 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 Minimize Scarring
The Bank of Canada cut the policy rate by 150 basis points in March 2020 to 0.25% and launched a large scale asset purchase program to support the recovery. The monetary policy stance will likely remain highly expansionary over the next 1-2 years, as long as medium-term inflation expectations remain anchored around the target. 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 were effective. Following the shock to markets in late March 2020, financial conditions improved, with credit spreads narrowing across a variety of markets and equity prices rebounding. Lending rates are now at record lows for most firms and households.
Bank earnings and asset quality remained solid in 2020, despite the COVID-19 shock, and the banking system is well-positioned to support the recovery. The vast majority of households and businesses that deferred loan repayments at the outset of the pandemic have resumed making repayments. Ongoing loan deferrals and government support programs may mask some underlying credit weakness, but given the significant increase in loan loss provisioning last year, the six large banks are in a strong position to absorb any potential 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-six 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 – and our view that some of the deterioration in credit and property price metrics from our scorecard are likely temporary - positively influences our “Monetary Policy and Financial Stability” building block assessment.
The housing market has heated up since the initial shock of the pandemic. Housing starts, sales, and prices have all surged past pre-pandemic highs. The market is being driven by very low mortgage rates and shifting preferences in favor of lower density areas and more spacious homes, all in the context of limited housing supply. Efforts to durably address affordability concerns will likely depend on the ability to increase the stock of housing. Demand pressures could intensify if immigration flows normalize over the next few years.
High household indebtedness continues to be a vulnerability even as household balance sheets in aggregate have improved over the last year. Net disposable income actually increased 10% in 2020 as government support programs more than offset lost income. With reduced spending options, households built up savings and paid down consumer debt. However, the high stock of debt may still cause financial stress for some borrowers. Low-income households and younger workers appear particularly vulnerable given that they have borne the brunt of the job losses and typically have less savings set aside.
The Canadian Economy Is Expected To Grow At A Moderate Pace In The Post-Pandemic Period
The IMF projects the Canadian economy to grow by 1.7% over the medium term. 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 labor productivity growth, which has lagged other advanced economies over the last three decades.
Canada’s external accounts do not exhibit any clear vulnerabilities. Exchange rate flexibility helps the economy adjust to evolving global conditions. In 2020, the current account deficit narrowed slightly to 1.9% of GDP on the back of lower travel services imports, as many Canadians were prevented from traveling abroad, and lower investment payments. Notwithstanding consistent current account deficits over the last decade, Canada has shifted from a net international liability position to a net asset position. External assets have benefited from buoyant global equity markets and local currency depreciation.
Strong Governing Institutions Are A Key Factor Underpinning The AAA Ratings
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 across a range of governance measures. The last federal election was in October 2019, when the Liberal Party won a plurality of seats and formed a minority government. As a result, the Liberals must seek out partners on a case-by-case basis to pass legislation.
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/375557.
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.
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/ (July 27, 2020). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/ (February 3, 2021).
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.
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 for use in the United Kingdom, and by DBRS Ratings GmbH for use in the European Union, respectively. The following additional regulatory disclosures apply to endorsed ratings:
Each of the principal methodologies employed in the analysis addressed one or more particular risks or aspects of the rating and were factored into the rating decision. Specifically, the “Global Methodology for Rating Sovereign Governments” (July 27 2020) was utilized to evaluate the Issuer, and “DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings” was used to assess ESG factors.
The last rating action on this issuer took place on September 22, 2020.
With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, 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
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. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.
Lead Analyst: Michael Heydt, Senior Vice President, Credit Ratings
Rating Committee Chair: Thomas R. Torgerson, Managing Director, Co-Head Global Sovereign Ratings
Initial Rating Date: October 16, 1987
For more information on this credit or on this industry, visit www.dbrsmorningstar.com.
140 Broadway, 43rd Floor
New York, NY 10005 USA
Tel. +1 312 696-6293