Morningstar DBRS Confirms Government of Canada at AAA Stable

DBRS Limited (Morningstar DBRS) confirmed the Government of Canada’s Long-Term Foreign and Local Currency – Issuer Ratings at AAA. At the same time, Morningstar DBRS 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 CREDIT 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 Morningstar DBRS’s view that Canada’s credit profile remains very strong despite ongoing macroeconomic challenges, including high albeit gradually decelerating inflation and substantial household indebtedness.

The Canadian economy has demonstrated resilience but is slowing under the weight of tighter monetary policy. Since the middle of last year, growth has downshifted to a below-trend pace. Household consumption has been relatively flat despite the surge in population. Higher financing costs and stricter lending standards have contributed to a decline in residential and non-residential investment. The strong growth in labour supply combined with softening demand has helped to rebalance the jobs market. The unemployment rate has increased from an unsustainably low level but the market continues to experience net job gains across most sectors. The housing market is starting to see signs of an uptick, suggesting that the price correction experienced in 2023 may have reached a turning point. Overall, we expect subdued economic growth through the first half of 2024 as the lagged impact of high interest rates continues to percolate. Nevertheless, growth is likely to accelerate gradually in the second half of the year as inflation moderates and financing conditions ease. The IMF projects GDP growth of 1.4% in 2024 and 2.3% in 2025.

Despite the deterioration in government debt metrics experienced following the pandemic, the outlook for Canadian public finances is generally positive. Gross general government debt is on a downward trend and expected to approach pre-pandemic levels within the next five years. The general government deficit is expected to increase marginally to 1.5% of GDP in FY24/25 compared to 1.4% in FY23/24. At the provincial level, fiscal results are expected to remain relatively sound.

CREDIT 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.

CREDIT RATING RATIONALE

Modest Fiscal Deficits Are Expected Over The Outlook Period

According to the Fall Economic Statement November 2023, the federal government is projected to run a fiscal deficit of 1.4% of GDP, or $40.0 billion, in FY23-24. This is largely in line with FY23-24 budget expectations. However, fiscal results could slightly underperform. In the first nine months of the fiscal year, the cumulative deficit increased to $23.6 billion, compared with $5.5 billion over the same period last year, and the final quarter of the fiscal year typically accrues the largest deficit. The weaker result largely stems from lower corporate income tax receipts (although receipts in February will be important to the full-year picture) as well as increased spending across most categories, including transfers to others levels of government and higher debt-servicing costs. Looking ahead, the government expects the deficit to gradually narrow to $18.4 billion, or 0.5% of GDP, by FY28-29. However, this forecast does not include the recently finalized Pharmacare Bill. This legislation will add to government expenses over the medium term, although the extent is unclear given that the financial commitment has not yet been announced. We could see some new spending measures focused on cost-of-living concerns in the upcoming budget, but we expect the government will balance those measures with the desire to avoid spurring inflation and to keep the debt-to-GDP trajectory on a downward path.

The gross general government debt ratio is high but has trended down since the initial shock of the pandemic. The IMF estimates that general government debt as a share of GDP declined from its peak of 119% in 2020 to 106% by 2023. The ratio is projected to decline to 103% in 2024 and then gradually decline to 95% by 2028 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 17 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.

After some deliberations, the government decided not to consolidate the Canada Mortgage Bond (CMB) program ($260 billion outstanding as of August 15, 2023) into the government’s borrowing program. Instead, the government plans to purchase up to $30 billion of CMBs annually, starting in February 2024. Increased purchases will be funded through increased regular government debt issuance. This will gradually reduce the amount of CMBs available to market participants, currently $260 billion with roughly $60 billion in net new issuance per year. While the additional issuance could modestly lift the gross government debt ratio, the offsetting financial asset implies that there will be no impact on net debt ratios.

The Bank Of Canada Signals End Of Tightening Cycle Is Near, Housing Markets May Have Reached an Inflection Point

Improving supply and moderating demand has led to positive news on the inflation front. In January 2024, year-over-year headline inflation declined to 2.9%, which is well below the peak of 8.1% in June 2022. Excluding food and energy, CPI came in at 3.1%. Slowing domestic demand and greater slack in the labour market should support the gradual disinflationary trend. However, two components of shelter prices – rents and mortgage interest costs – continue to rise quickly and complicate the outlook. For example, mortgage interest costs, which constitute 3.8% of the CPI basket, increased 27.4% year-over-year in January.

The Bank of Canada has increased the policy rate cumulatively by 475 basis points since it started the tightening cycle in March 2022. Furthermore, the central bank initiated quantitative tightening in April 2022, in which it has allowed its holdings of government bonds to run off the balance sheet as the bonds mature. On January 24, 2024, the Bank of Canada maintained the policy rate at 5.0% and indicated that the focus of monetary policy going forward would be on deciding how long to maintain the high level of interest rates. The Bank of Canada noted that economy is now in a position of modest excess supply. However, policymakers did not rule out the possibility of raising interest rates further should the progress on inflation start to reverse.

The Canadian housing market continues to adjust to the high interest rates, surging population growth, and affordability constraints. Prices have remained soft after finding a floor early in early 2023, however sales and prices have picked up. Sales activity increased 17.7% in January relative to one year ago, although still 38% below the level reached in March 2021. Prices remained largely stable increasing by a modest 0.8% YOY in January 2024, though still down 18% compared to the March 2022 peak. The market appears to be in a generally balanced position with sales to new listings hovering near the ten-year average. Given the rapid pace of population growth, new housing supply is unlikely to keep up with demand. Pent up demand and the pace of population growth are expected to bolster housing activity in the second half of the year, thereby implying an upside to prices is more likely than a downside and, in turn, worsening the affordability problem.

Although household balance sheets in aggregate have improved since the start of the pandemic, high household indebtedness remains a vulnerability. 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. The strong labor market has helped to bolster incomes. Nevertheless, 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. Outstanding mortgage balances that were insured at origination or through portfolio insurance obtained by the banks has declined to about one-fourth given growth in uninsured mortgages. However, 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. The large banks remain highly capitalized, and we note that banks have increased their provisioning for risks specifically in the CRE office sector, corporate and retail portfolios. While the banks are well-positioned, we make a one-category adjustment to the ‘Monetary Policy and Financial Stability’ building block assessment to reflect risks related to imbalances in the housing prices and other pockets of vulnerabilities including the CRE portfolio.

The Canadian Economy Is Expected To Grow At A Moderate Pace Over The Medium Term

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 and subdued business investment also appear to be impeding labor productivity growth, which has lagged other advanced economies over the last three decades. Elevated immigration should bolster growth in the near term and help counter ageing effects, but its contribution to growth will likely subside as immigration levels normalize over time.

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 widened slightly from 0.4% of GDP in 2022 to 0.6% in 2023. Although Canada has run current account deficits for most of the last decade, the country’s net international asset position has increased. In the third quarter of 2023, the net asset position reached 48.4% of GDP. This reflects large valuation gains of Canadian residents’ direct investments and equity holdings abroad relative to the increase in foreigners’ direct investments and debt holdings in Canada.

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 for NDP support on confidence and budget votes through 2025, when the next federal election is required to take place. The Pharmacare deal, which is a key aspect of the confidence-and-supply agreement, is set to be tabled in March and should help the Liberals push off an election until next year.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
There were no Environmental, Social, or Governance factors that had a significant or relevant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (23 January 2024) https://dbrs.morningstar.com/research/427030/morningstar-dbrs-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/429087.

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 (06 October 2023) https://dbrs.morningstar.com/research/421590/global-methodology-for-rating-sovereign-governments. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS’ outlooks and credit 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 dbrs.morningstar.com.

The credit rating was not initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for this credit rating action.

Morningstar DBRS did not have access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is a solicited credit rating.

This credit 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 credit 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 Morningstar DBRS historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication. For further information on Morningstar DBRS historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

Lead Analyst: Travis Shaw, Senior Vice President, Public Finance
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 dbrs.morningstar.com.

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