DBRS Morningstar Confirms Government of Canada at AAA Stable

DBRS Limited (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 high inflation and a slowing economy.

Following a strong first half, the Canadian economy lost momentum late in the year. GDP grew at an annualized pace of 2.3% (q/q) in the third quarter and 0.0% (q/q) in the fourth quarter. Slower momentum was driven by weaker inventory accumulation, as well as business and housing investment, which were partly mitigated by growth in consumer spending, higher exports and reduced imports. However, the labour market remains extremely tight with the unemployment rate at 5.0%, and the latest employment report showing considerable strength. The housing market continues to adjust to higher interest rates, with a marked decline in sales and prices. We expect the housing adjustment to continue through 2023. The IMF projects growth of 1.5% in 2023 and 1.6% in 2024. However, with external demand weakening, we think risks to the 2023 forecast are clearly skewed to the downside.

Despite the deterioration in public finance metrics experienced following the pandemic, a robust economic recovery and unwinding of extraordinary fiscal support, are leading to a favourable turnaround in Canadian public finances. Gross general government debt is now firmly on a downward trend and expected to return to pre-pandemic levels over the medium term. Similarly, the federal budget deficit is expected to come in around 1.1% of GDP in FY23/24, 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

The federal fiscal deficit remains in a sustainable position and continues to improve. According to the Fall Economic Statement (the FES; November 2022), the deficit is projected to narrow to 1.3% of GDP, or $36.4 billion, in FY22-23 and 1.1% of GDP in FY23-24 – both improved from original budget expectations. Furthermore, based on data through the first nine months of the fiscal year, further outperformance is likely as the year-to-date deficit amounts to just $5.5 billion. The improvement is being driven by higher revenues, helped by strong growth in nominal GDP, and a lapse in pandemic-related spending. In outer years the FES points to gradually declining deficits before achieving a small surplus in FY27-28; however, this did not include the recently announced enhanced provincial healthcare transfers (see Federal-Provincial Healthcare Funding: A 10-Year Booster Shot) which will have a negative impact on fiscal performance, albeit quite modest. With a heightened focus on cost-of-living pressures we could see some further affordability measures in the federal 2023 budget – anticipated in the coming weeks – along with the impact of slowing macroeconomic conditions, but the overall fiscal outlook is expected to remain manageable.

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 102% by 2022, and the ratio is projected to decline to 99% in 2023 and 89% by 2027 which, if achieved, would be close to pre-pandemic levels.

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 18 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 Canadian Economy Is Expected To Grow At A Moderate Pace In The Post-Pandemic Period

The IMF projects the Canadian economy to grow by 1.5% 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 labour productivity growth, which has lagged other advanced economies over the last three decades. On a positive note, the federal government continues to increase immigration targets which is contributing to robust population growth, helping to counter ageing effects, and address labour shortages.

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 a deficit of 1.8% of GDP in 2020 to a surplus of 0.5% in 2022. 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 (21% of GDP in the third 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.

The Bank Of Canada Takes A Pause As Inflation Shows Signs Of Moderation And The Housing Market Continues To Adjust

After peaking at 8.1% in June 2022, inflation is showing signs of moderation. As of January 2023, headline inflation declined to 5.9% from 6.3% in December 2022, although this was largely a base-year effect as the threat of a Russian invasion of Ukraine, along with supply chain disruptions and increased prices for housing were contributing to significant upward price pressure at the start of 2022. Lower prices for cellular services and a deceleration in passenger vehicle price growth more than offset higher gas prices, mortgage interest, and meat prices relative to the prior month. Further indications that supply bottlenecks are easing and commodity prices are stabilizing at lower levels, along with ongoing adjustments in the housing market, may provide additional relief in the coming quarters. Annualized monthly core inflation excluding vehicles and travel services (3 month average) has moderated to 1.2% in January 2023.

The Bank of Canada has taken a temporary pause in its monetary policy tightening cycle. Having raised the overnight rate by a cumulate 425 basis points between March 2022 and January 2023, the Bank of Canada held rates steady on March 8, 2023 while it assesses the impact of previous increases. Furthermore, quantitative tightening which began in April 2022, continues as the Bank of Canada allows its holdings of government bonds to run off its balance sheet as the bonds mature. No further rates hikes are anticipated this year, although risks are tilted to the upside should high inflation persist and consumer demand remain strong.

The Canadian housing market continues to adjust to the rapid increase in interest rates and affordability constraints. Following the initial shock of the pandemic, housing prices and sales activity accelerated rapidly but recent data indicates that a significant correction is underway. In January 2023, some sales nationwide were down 48% compared to the recent peak reached in March 2021, while prices were down by 19% compared to the March 2022 peak. In some major cities, the decline has been more pronounced: home sales in the Greater Toronto Area (GTA) and Metro Vancouver were both down by 47% in February 2023 compared to the same period a year ago. As consumers adjust to higher rates, there is likely further downside to house prices throughout the remainder of 2023 and possibly into 2024. The price adjustment may contribute to a moderation in residential investment 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.

High household indebtedness remains a vulnerability as borrowing costs increase. Household net disposable income increased 4% in 2021, and again in 2022 as labour markets remained strong. 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 although these have moderated of late. Household debt levels remain high, and with interest rates now elevated, 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 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 2023 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.

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-andgovernance-risk-factors-in-credit-ratings (May 17, 2022).

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/410717.

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). In addition DBRS Morningstar uses 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 (17 May 2022) in its consideration of ESG factors.

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 related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found on the issuer page at www.dbrsmorningstar.com.

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:

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: Travis Shaw, 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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