DBRS Confirms Government of Canada at AAA and R-1 (high), Stable

DBRS Inc. (DBRS) has confirmed the Long-Term Local and Foreign Currency Issuer Ratings of the Government of Canada at AAA as well as its Short-Term Local and Foreign Currency Issuer Ratings at R-1 (high). The trend on all ratings is Stable.

The AAA ratings reflect Canada’s sound macroeconomic management, strong institutions, and stable political environment. Sound macroeconomic management is evident by the country’s open, competitive and wealthy economy, its credible fiscal planning, and a well-regulated financial system. These features have facilitated low financing costs and grant the government a high capacity to service its comparatively low level of debt.

The Stable trend reflects DBRS’s view that the challenges facing Canada are manageable. A prolonged period of low commodity prices, combined with financial risks stemming from elevated housing prices and household debt, could challenge Canada’s longer-term growth prospects. Should the new U.S. administration introduce protectionist measures that undermine North American trade, it would adversely affect Canada, as the majority of its trade and foreign investment flow across the U.S.-Canada border. However, DBRS believes that credible public institutions and effective medium-term policy planning mitigate these risks. The sound fiscal position of the government provides space for the Trudeau administration to increase capital expenditures. While the stimulus is expected to boost near term growth and partially offset the impact of the 2014 oil price decline, its long-term effect on productivity will be determined by the efficiency of the new spending.

Despite slower GDP growth from the oil price decline, Canada’s economy is wealthy and open. The sharp decline in the price of oil has weighed on all expenditure components of output. Growth declined to 1.1% in 2015 and is expected at 1.2% this year, after average growth of 2.5% from 2010-14. The oil shock as well as the wildfires in Alberta and Saskatchewan led to weaker business investment and fed through to a slowdown in private consumption, particularly in resource-rich provinces. However, the depreciation of the exchange rate helped balance the terms of trade shock by offsetting deflationary pressure and supporting non-resource exports. DBRS expects accommodative monetary policy, infrastructure spending, and an open immigration policy to support domestic consumption. The economy is expected to average growth of 1.9% from 2017-2021.

Canada’s strong track record of prudent fiscal policy and sound debt management supports the government’s expansionary 2016 budget. The new Liberal Party government has shown a higher tolerance for fiscal deficits. After the federal government registered a small deficit in 2015-16, the deficit is expected at 1.2% of GDP in 2016-17 and 1.3% in 2017-18, before improving in the following years. The budget targets new and existing investments worth C$186 billion, or 7.4% of GDP, over the next decade on infrastructure projects. The government has also committed resources through the creation of an infrastructure bank. Still, historical episodes of underspending on capital relative to budgets raise some uncertainty regarding these investments.

This shift towards a more expansionary fiscal policy has only marginally weakened the federal government’s balance sheet. Assuming economic recovery, the federal debt is expected to remain below 32% of GDP until the end of the decade and decline slowly thereafter. While provincial government debt is much higher, general government debt is 92% of GDP, large provinces (Ontario, Quebec, and British Colombia) have improved balance sheets. Public debt is offset by sizable liquidity buffers and a favorable maturity and funding profile.

The ratings are also supported by Canada’s resilient financial system. With persistently high capitalization levels, profitability, and asset quality, the standalone strength of the Canadian banks is strong. The World Economic Forum consistently recognizes the banking system as the soundest in the world. Stress tests show that it could withstand a large shock to property prices without requiring additional capital.

However, Canada’s financial sector has interrelated vulnerabilities around elevated property prices and household debt. Over the past ten years, supply constraints, employment growth, low interest rates, and high demand for housing in urban centers and resource-rich provinces have been responsible for a doubling of mortgage debt, causing real estate prices to increase by 55% over the same period. High demand for mortgage borrowing perpetuated the three decade increase in household debt. Notwithstanding, structural features of the Canadian financial system and macro prudential policies – including high down payment requirements and mandatory insurance for riskier mortgages – dampen risks stemming from the housing market.

Lost external competitiveness is in part a structural challenge. The fifteen year decline in the trade balance, from a surplus of 7% of GDP to a 2.5% of GDP deficit between the second quarters of 2001 and 2016, is represented by the deterioration of key product categories in the export basket. The long-run declining trade balance of motor vehicle parts, for instance, demonstrates a structural loss of competitiveness. Yet, proposals by the Advisory Council on Economic Growth have the potential to increase productive capacity. The recently signed trade agreement with Europe is also expected to increase and diversify trade and investment flows.

RATING DRIVERS
Canada’s credit profile could come under pressure if a prolonged period of lower economic growth leads to a material deterioration in fiscal performance and rising debt. The credit profile could also be negatively affected if financial sector vulnerabilities were to significantly increase, triggered by imbalances in the housing market and high household debt.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales. These can be found at http://www.dbrs.com/about/methodologies.

The sources of information used for this rating include the Department of Finance, Statistics Canada, Bank of Canada, Bank for International Settlements, International Monetary Fund, Organisation for Economic Co-operation and Development, World Bank, Haver Analytics. DBRS 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. DBRS did not have access to the accounts and other relevant internal documents of the rated entity or its related entities.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

Lead Analyst: Jason Graffam
Rating Committee Chair: Roger Lister
Initial Rating Date: October 16, 1987
Most Recent Rating Update: October 2, 2015

For additional information on this rating, please refer to the linking document under Related Research.