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

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 very strong despite emerging macroeconomic challenges, including high inflation and a slowing housing market.

The Canadian economy expanded at a robust pace in the first half of 2022. GDP grew at an annualized pace of 3.1% (q/q) in the first quarter and 3.3% (q/q) in the second quarter. Consumers increased spending, particularly on services, amid better health conditions and pent-up demand, while firms boosted capital outlays. However, momentum in recent months has slowed amid tighter monetary policy, high inflation, and a slowdown in the housing market. The labor market shows very little slack, with the unemployment rate at a 50-year low of 4.9%, but recent jobs data points to some cooling. The housing market is rapidly adjusting to rising borrowing costs, with a sharp and broad-based slowdown in sales, and prices are starting to fall in and around some major cities, such as Toronto and Vancouver. The IMF projects growth of 3.4% in 2022 (which implies limited growth in the second half of the year given the statistical carryover) and 1.8% in 2023. With external demand weakening, we view risks to growth in 2023 as skewed slightly to the downside.

Some public finance metrics have deteriorated as a result of the extraordinary policy stimulus delivered during the pandemic, but the rapid economic recovery and withdrawal of fiscal support bode well for Canadian public finances. Gross general government debt was 25 percentage points of GDP higher in 2021 than in 2019. Nevertheless, the government debt ratio is now projected to be on a firm downward trajectory, supported by strong fiscal results and moderate medium-term growth prospects. The federal budget deficit is expected to come in below 2.0% of GDP in FY22/23, down from 14.9% in FY20/21, while fiscal results at the provincial level have also rapidly improved.

RATING DRIVERS

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.

RATING RATIONALE

Fiscal Accounts Have Rapidly Returned To A Sustainable Position

According to the FY22-23 budget, the federal deficit is expected to decline from the pandemic-related peak of 14.9% of GDP in FY20-21 to just 2.0% in FY22-23. Early data from this fiscal year suggests that the budgetary result will likely outperform the 2.0% projection. The federal government posted a modest surplus in the first quarter of the year (April to June). Overall, the large and rapid improvement in the fiscal accounts has been driven by sharply higher revenue, which is benefiting from strong nominal GDP growth, as well as lower outlays, as pandemic-related programs have been wound down. With provincial budget results also significantly improving over the last year, the combined fiscal policy stance across the general government (i.e. federal plus provincial plus municipal governments) has returned to a sustainable position.

The government debt-to-GDP ratio is markedly higher than before the pandemic but the trajectory is now firmly downward. The IMF estimates that gross debt-to-GDP for the general government increased from 87% in 2019 to 118% in 2020. The ratio declined to 112% in 2021 amid a strong economic recovery and better fiscal results, and the ratio is projected to decline to 102% in 2022 and 88% in 2027, which is close to the debt ratio prior to the pandemic.

Two other factors highlight that the government balance sheet is in relatively good shape. 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. Furthermore, while Canada’s gross debt-to-GDP is high, the ratio is approximately 19 percentage points lower if you exclude accounts payable, which improves comparability across countries. These two factors, combined with the declining debt-to-GDP trajectory, account for the uplift in the “Debt and Liquidity” building block assessment.

The Bank Of Canada Is Tightening Monetary Policy To Curb High Inflation, Leading To An Adjustment In The Housing Market

Headline inflation declined to 7.6% (y/y) in July after reaching 8.1% in June, the fastest pace in nearly 40 years. High inflation is partly due to supply-related factors. Food and energy prices, which were already rising at a rapid pace at the start of the year, were driven higher by the Russian invasion of Ukraine and the subsequent sanctions and counter-sanctions. Supply constraints also persisted in the auto sector, which continued to push vehicle prices higher. At the same time, demand for travel-related services, such as accommodation and airfare, rebounded as health conditions improved, which added to overall inflation pressures. Recent declines in commodity prices, some tentative signs of supply bottlenecks easing, and the commencement of an adjustment in the housing market may provide some relief over the next few months. However, the primary driver of inflation has shifted from pandemic- and geopolitical-related supply shocks to excessive domestic demand. Monthly core inflation excluding vehicles and travel services accelerated in the first half of 2022, highlighting the breadth of inflationary pressures. Annualized monthly core inflation excluding vehicles and travel services (3 month average) has moderated slightly but was still 5.9% in July. These price dynamics indicate that even as headline inflation may have peaked, underlying inflationary pressures continue to run hot.

The Bank of Canada has accelerated the pace of monetary policy tightening in response to strengthening inflation. The Bank of Canada raised the overnight rate by 25 basis points in March, 50bps in both April and June, 100bps in July, and 75bps in September. Those moves brought the policy rate to 3.25%, which is just above the estimated range for the neutral rate of 2-3%. The Bank of Canada also initiated quantitative tightening in April, with its holdings of government bonds set to run off its balance sheet as the bonds mature. Another 25-75 basis points in hikes are expected by the end of the year, thereby taking the policy rate to 3.5-4.0%. Such actions would clearly put monetary policy in a restrictive stance.

The Canadian housing market is rapidly adjusting to rising rates and affordability constraints. The market heated up after the initial shock of the pandemic. Prices nationwide were up by 52% in March 2022 relative to two years prior, and inventory hit a record low at the start of 2022. However, recent data points to a sharp and broad-based slowdown. Home sales nationwide in July were down 31% compared to February, placing monthly sales slightly below the pre-pandemic historical average. In some major cities, the decline was more acute: home sales in the Greater Toronto Area (GTA) and Vancouver were down by 42% and 44%, respectively, over the five-month period. Inventories across the country also increased, as new listings have held up so far. Against this backdrop, prices are starting to adjust. While prices are stabilizing in parts of the country, Ontario is seeing prices decline. Home prices in the GTA have fallen by 7% since peaking in February, with even larger declines in some smaller cities close to the GTA. We expect prices nationwide to decline during the rest of 2022 and in 2023, as markets adjust to higher rates. The price adjustment may contribute to a moderation in residential investment over the next year but robust household formation and limited supply will continue to support housing construction over the medium term. In our view, efforts to durably address affordability problems in parts of the country, such as Toronto and Vancouver, will primarily depend on increasing the stock of housing.

Although household balance sheets in aggregate have improved since the start of the pandemic, high household indebtedness continues to be a vulnerability as borrowing costs increase. Net disposable income actually increased 9% in 2020 as government support programs more than offset lost income, and rose another 3% in 2021 as labor markets recovered. With reduced spending options during the pandemic, households built up savings and paid down consumer debt. Buoyant equity and housing markets further bolstered the asset side of the balance sheet. However, household debt levels remain high, driven in part by strong mortgage borrowing over the last two years. With interest costs now rising, the high level of debt may end up causing financial stress for some borrowers, particularly lower-income and younger workers that may have stretched to buy a home in the last two years and have less savings set aside.

Canadian banks will likely benefit from higher rates and are relatively well-positioned to weather an adjustment in the housing market. Several factors point to resilience in the banks’ domestic mortgage portfolios. Mortgage insurance rules and lending standards have been incrementally tightened over the last decade, which helps contain risks of deteriorating asset quality. Nearly one-third of outstanding mortgage balances were insured at origination or through portfolio insurance obtained by the banks. Of those mortgages that are uninsured, the loan-to-value ratios are below 80%, which provides banks with greater protection to a housing price shock. In addition, the large banks entered 2022 highly capitalized (although they are looking to deploy capital organically, through acquisitions, through share buybacks or some combination of the three). Our assessment of the measures taken by authorities to reduce financial stability risks 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 1.6% 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 and subdued business investment also appear to be impeding labor productivity growth, which has lagged other advanced economies over the last three decades. On a positive note, ambitious new immigration targets announced by the federal government in February 2022 will contribute to robust population growth and help counter ageing effects.

Canada’s external accounts do not exhibit any clear vulnerabilities. Exchange rate flexibility helps the economy adjust to evolving global conditions. The current account shifted from deficit of 1.8% of GDP in 2020 to a surplus of 0.2% in the second quarter of 2022 (rolling four quarters). The change was primarily driven by higher commodity export prices. Although Canada has run current account deficits for most of the last decade, the country’s net international asset position has increased as a share of GDP (45% of GDP in the first quarter of 2022). During this period, Canadians’ assets abroad have rapidly grown on the back of large direct investments abroad, buoyant global equity markets as well as foreign currency appreciation.

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 Worldwide Governance Indicators, Canada ranks highly compared to other advanced economies across a range of governance measures.

The Liberal Party returned to power with a minority mandate following the September 2021 election. Six months later, the Liberals reached a confidence-and-supply agreement with the NDP, in which the Liberals agreed to advance some NDP priorities, such as national dental care and pharmacare programs. In return, the NDP agreed to support the Liberals in confidence and budget votes through 2025, when the next federal election is scheduled to take place.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

There were no Environmental/ Social/ Governance factor(s) that had a significant or relevant effect on the credit analysis.

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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/402548.

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 https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments (August 29, 2022). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings, https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022).

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, 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:

The last rating action on this issuer took place on March 11, 2022.

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: https://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

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