Morningstar DBRS Confirms Government of Canada at AAA, Stable
SovereignsDBRS 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 weak productivity growth and poor housing affordability.
The Canadian economy has demonstrated resilience as robust population growth and a strong labour market have helped mitigate the impact of higher interest rates. Nevertheless, growth has downshifted since the middle of last year. Household consumption has been relatively weak despite the surge in population. Higher financing costs and subdued housing market activity have contributed to a decline in residential investment while business investment has turned positive. The strong growth in labour supply combined with softening demand has helped to rebalance the jobs market. The unemployment rate is increasing as the labour market is no longer able to absorb the rapid growth in population, though job losses have yet to accelerate. The housing market also appears to be better balanced, although activity is relatively subdued. While the economy experienced moderate growth through the first half of 2024, activity 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 1.2% 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 1.1% of GDP in FY24/25 compared to 0.6% in FY23/24. At the provincial level, the fiscal outlook has deteriorated modestly but is 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 While Debt-to-GDP Continues To Moderate
The federal deficit forecast remains broadly in line with the targets laid out in the November 2023 Fall Economic Statement (FES) and the government's fiscal anchors are unchanged. The government aims to maintain a declining deficit-to-GDP ratio (falling below 1.0% by 2026-27 and beyond) while also reducing the federal debt-to-GDP ratio over the medium term. The deficit is estimated at 1.3% of GDP in FY24-25, a slight improvement compared to the deficit of 1.4% in FY23-24. The budget projects that the deficit will gradually decline to 0.6% of GDP by FY28-29, which is slightly higher than projected in the FES. Early data from this fiscal year indicates that performance is on track with budget expectations as the federal government has posted a slight deficit through the first three months of the year (April to June). Revenue gains driven by the better economic outlook and new tax measures will be offset by spending increases in priority areas, including housing affordability, disability benefits, childcare expansion, strengthening defense capabilities and funding for the new pharmacare program, which is a key aspect of the confidence-and-supply agreement with the NDP. Compared to the FES, higher nominal GDP growth projections will generate additional revenues of $29.1 billion over the forecast period. This, along with tax increases amounting to $21.9 billion (most notable being an increase in the capital gains inclusion rate), will largely offset the proposed spending package of $57 billion. Provincial budgetary projections are pointing to modest deterioration compared with the prior fiscal year, leading to a combined fiscal policy stance across the general government (i.e. federal plus provincial plus municipal governments) that has taken a step back but remains in a sustainable position.
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 118% in 2020 to 107% by 2023. The ratio is projected to decline to 105% in 2024 and then gradually decline to 95% by 2029 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.
The Bank Of Canada Begins Easing Cycle, Housing Market Balanced But Affordability Remains A Concern
Moderating demand is allowing inflation to continue trending down towards the Bank of Canada's (BoC) 2.0% target. In July 2024, year-over-year (YOY) headline inflation declined to 2.5%, which is well below the peak of 8.1% in June 2022. Excluding food and energy, CPI came in at 2.7%. Slowing domestic demand and increasing slack in the labour market are reducing upward pressure on prices. Although still rising quickly, the pace of growth in rents and mortgage interest costs is moderating which is also contributing to a more favourable headline CPI result. Mortgage interest costs rose by 21.0% YOY in July 2024, while rents rose by 8.5% YOY ¿ both down from the prior month.
On June 5, 2024, the Bank of Canada (BoC) lowered its policy rate by 25 basis points, the first rate cut in more than four years. It was also the first G7 central bank to begin easing this cycle. The BoC followed with further 25 basis point rate cuts on July 24, 2024, and September 4, 2024, bringing its target policy rate to 4.25%. The BoC noted that excess supply has increased as strong population growth is boosting potential output faster than GDP. With household spending having been relatively weak and the labour market continuing to show signs of slack, the BoC is widely expected to continue easing through the remainder of 2024. The next scheduled announcement is on October 23, 2024.
The Canadian housing market appears relatively balanced. Homebuyers continue to adjust to the higher interest rate environment, and the recent downward movement in mortgage rates has yet to reignite demand. Sales activity has remained somewhat subdued, down 3.5% in July 2024, relative to one year ago, and almost 40% below the level reached in March 2021. Meanwhile prices have exhibited some moderation, down 3.7% YOY in July 2024, and still 15% below the March 2022 peak. Furthermore, recent announcements to reduce the number of temporary foreign workers and potentially also reduce the number of new permanent residents accepted each year, are likely to keep housing market activity relatively subdued in the near term. Although constrained by municipal zoning regulations, development fees, availability of skilled labour, etc., efforts across levels of government to boost the supply of housing ¿ especially affordable housing ¿ are keeping housing starts elevated. Nevertheless, affordability remains a concern and any material improvement on that front will be dependent on a combination of sustained reduction in mortgage rates, house prices, and/or sustained increase in personal incomes.
Although household balance sheets in aggregate have improved since the start of the pandemic, high household indebtedness remains a vulnerability. Buoyant equity and housing markets bolstered the asset side of the balance sheet while a strong labour market bolstered incomes. Both the housing market and labour market have moderated of late and household debt levels remain high. While the adjustment to higher interest rates is well underway and mortgage rates now trending down, there remain a portion of borrowers still subject to higher interest costs upon mortgage renewals over the next couple of years. 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 and have less savings set aside.
Canadian banks are relatively well-positioned to weather any adverse developments in the Canadian housing market. 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. Several factors point to resilience in the banks' domestic uninsured mortgage portfolios. The mortgage stress test uses a minimum qualifying rate at origination and, therefore, provides a buffer for borrowers to absorb interest rate increases. Additionally, credit quality related to uninsured mortgages remains solid at Canada's large banks reflecting strong borrower credit scores, and low average loan-to-values provide adequate cushion to absorb housing price declines. The large banks remain well capitalized, and we note that banks have materially ramped up provisioning to address credit risks, specifically in the CRE office sector, corporate and unsecured 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 into 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 has helped to counter ageing effects, but its contribution to growth is expected to subside as the government has announced plans to reduce the proportion of non-permanent residents and targets for permanent residents are likely to be revised downward also.
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 first quarter of 2024, the net asset position reached 68% 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 has been in power since 2015, having secured its third consecutive mandate and second consecutive minority government following the September 2021 election. The Liberals have been supported by 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. On September 4, 2024, the NDP announced that they would be terminating the confidence-and-supply agreement early. While the next federal election is scheduled to take place in October 2025, an early election is now possible should the government lose a vote of confidence in the House of Commons. The Conservative Party of Canada, under Pierre Poilievre, have been leading in the polls by a wide margin for much of the past year.
ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/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 Factors in Credit Ratings (13 August 2024) https://dbrs.morningstar.com/research/437781.
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://dbrs.morningstar.com/research/439060.
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 (15 July 2024) https://dbrs.morningstar.com/research/436000. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings https://dbrs.morningstar.com/research/437781 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.
These credit ratings are 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, Sector Lead
Rating Committee Chair: Thomas R. Torgerson, Managing Director,
Initial Rating Date: October 16, 1987
For more information on this credit or on this industry, visit dbrs.morningstar.com.
DBRS Limited
DBRS Tower, 181 University Avenue, Suite 700
Toronto, ON M5H 3M7 Canada
Tel. +1 416 593-5577