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 DBRS Morningstar’s view that Canada’s credit profile remains strong despite the economic and health impact of the pandemic. Sound management of economic policy is expected to continue after the September 20th federal election.
Despite weaker-than-expected growth in second quarter and the recent increase in Covid-19 cases, the Canadian economy looks set to recover at solid pace in the second half of this year. GDP contracted by 1.1% q/q (annualized) in the second quarter of 2021 and preliminary activity data in July points to weak momentum going into the third quarter. The underwhelming performance is primarily due to tighter social distancing restrictions amid the third wave of the coronavirus cases in April and May. However, in DBRS Morningstar’s view, the recovery is still primed to accelerate over the next few quarters. Easing restrictions, highly accommodative macroeconomic policies, and consumers’ willingness to spend part of their excess savings should drive domestic demand. Covid-19 infections are rising but the level of hospitalizations and deaths remains low, and 70% of Canadians are fully vaccinated. Higher commodity prices and strong external demand from the United States should further support growth. Notwithstanding the positive near-term outlook, there are mounting downside risks, including disruptions due to the Delta variant outbreak and intensifying supply chain bottlenecks, which threaten to dampen the pace of the recovery.
The government has delivered an extraordinary level of fiscal and monetary support to head off economic scarring. The federal government estimates that the deficit reached 16.1% of GDP in FY20-21. However, policy support is expected to be withdrawn as health conditions improve and the economy recovers. Overall, we view the fiscal response positively. Some public finance metrics deteriorated due to scale of the support. Gross government debt-to-GDP is projected to increase 24 percentage points from 2019 to 2021. However, the debt ratio is expected to be on a downward trajectory due to fiscal consolidation and a robust recovery, and debt servicing costs remain low.
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.
Fiscal Policy Support Is Being Gradually Removed As Health Conditions Improve And The Economy Recovers
The emergency fiscal spending in response to the pandemic has been massive in scale but temporary in design. According to the FY21-22 budget, the deficit is estimated to have reached $355 billion (16.1% of GDP) in FY20/21, up from $39 billion (1.7%) the prior year. The deficit is expected to decline quickly as the economy recovers. The FY21-22 budget forecasts the deficit to narrow to $155 billion (6.4% of GDP) in FY21/22, to $60 billion (2.3%) in FY22/23, and then down to $31 billion (1.1%) by FY25/26. While new spending proposals announced during the federal election could add some upside risk the deficit trajectory, both the Liberals and the Conservatives have laid out similar deficit-reduction plans over the next five years.
The large fiscal deficits combined with the deep recession has led to markedly higher government debt. The IMF projected in July 2021 that debt-to-GDP for the general government (i.e. federal plus provincial plus municipal governments) will increase from 87% in 2019 to 111% 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 are winding down as health 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. The nominal yield on the 10-year government bond averaged 1.4% over the last six months. 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 the pandemic. 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 Central Bank Will Gradually Withdraw Monetary Policy Support As Higher Inflation Is Viewed To Be Transitory
The Bank of Canada is tapering asset purchases while maintaining the policy rate at the lower effective bound of 0.25%. The central bank started to reduce weekly purchases of government bonds in October 2020 from $5 billion per week to $4 billion. By July 2021, weekly purchases were down to $2 billion. Monetary policy settings will remain highly accommodative over the next 3-4 quarters, but policy support looks set to be gradually withdrawn as output and employment recover. The first increase in the policy rate is expected in the second half of 2022. Inflation hit 4.1% in August, which is well above the upper bound of the central bank’s target range. The central bank expects inflation to moderate in 2022, as supply-demand imbalances diminish and commodity price adjustments are fully absorbed. Medium-term inflation expectations remain anchored around the 2% target.
Canada’s booming housing market has started to cool amid low inventories and high prices. Market activity increased rapidly in the second half of 2020 and in early 2021, driven by very low mortgage rates and the shift in preferences toward lower density areas and more spacious homes. However, housing starts and sales have recently declined, albeit from historically high levels, and house price growth has slowed. Sales and price growth could moderate further in the near term as activity related to changing preferences is fully absorbed. Over the longer term, efforts to address affordability will depend on the ability to increase the stock of housing.
High household indebtedness continues to be a vulnerability even as household balance sheets in aggregate have improved since the outbreak of the pandemic. 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. At the same time, buoyant equity and housing markets bolstered the asset side of the balance sheet. However, the high stock of debt may still cause financial stress for some borrowers, particularly low-income workers and younger workers. These households faced the most severe job losses last year, are more likely to work in sectors that have not fully recovered, and typically have less savings set aside.
Overall, the banking system is well-positioned to support the recovery. Bank earnings and asset quality remained strong in 2020 and the first half of 2021. The vast majority of households and businesses that deferred loan repayments at the outset of the pandemic have resumed making repayments. As loan deferral and government support programs wind down, some underlying credit weakness may materialize; however, the six large banks are in a strong position with sufficient loan loss provisions and capital levels to absorb 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, one-third 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 temporary - positively influences our “Monetary Policy and Financial Stability” building block assessment.
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. However, 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. The current account deficit narrowed from 2.1% of GDP in 2019 to 0.4% in the second quarter of 2021 (rolling 4 quarters). The smaller deficit was driven by 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 large net asset position. Canadians’ assets abroad have increased rapidly on the back of 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.
Federal elections were held on September 20th. It appears that the Liberal Party won the most seats but was unable to reach a majority. DBRS Morningstar expects broad continuity in terms of economic policymaking following the election. Please see the Commentary “Direction Of Economic Policymaking In Canada Seems Clear Despite Approaching Federal Elections” for more information.
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/384790.
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/381451/global-methodology-for-rating-sovereign-governments (July 9, 2021). 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/dbrs-morningstarcriteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (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 the 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/principal asset class 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 9, 2021) was utilized to evaluate the Issuer, and “DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings” (February 3, 2021) was used to assess ESG factors.
The last rating action on this issuer took place on March 19, 2021.
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, Credit Ratings
Initial Rating Date: October 16, 1987
For more information on this credit or on this industry, visit www.dbrsmorningstar.com.
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