DBRS Confirms Government of Canada at AAA Stable

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

KEY RATING CONSIDERATIONS

The AAA ratings are underpinned by Canada’s large and diverse economy, prudent macroeconomic policymaking, and strong public institutions. The Canadian economy is operating close to full capacity. The unemployment rate is at a 10-year low. Business investment is picking up amid strong demand and limited spare capacity. Moreover, the preliminary agreement on NAFTA has reduced uncertainty regarding the future of the North American trading relationship.

Against this positive backdrop, policymakers are gradually withdrawing accommodative fiscal and monetary policies. Growth is moderating towards potential but remains robust and broad-based across industries. Higher interest rates and tighter mortgage rules are helping cool the housing market in an orderly manner, thereby easing concerns of elevated housing prices in the Vancouver and Toronto areas. Nevertheless, the outlook is subject to downside risks. The potential for escalating trade tensions globally could dampen external demand, and elevated levels of household debt leave the economy vulnerable to employment and interest rate shocks.

RATING DRIVERS

The Stable Trend reflects DBRS’s view that Canada has a high capacity to absorb shocks and cope with pending challenges. The ratings could experience downward pressure in the medium term, however, if a large shock were to significantly weaken growth prospects and fiscal outcomes, resulting in a sustained deterioration in public debt dynamics and policy credibility.

RATING RATIONALE

Strong Public Finances Support the AAA Ratings

Canada has a record of sound budgetary management. Fiscal policy provided support in the economy in the aftermath of the 2014 oil-price shock. However, policy has moved to a more neutral setting this year as spare capacity in the economy has diminished. Over the coming years, DBRS expects policy to tighten modestly. The federal government aims to reduce the deficit from 0.8% of GDP in FY2018-19 to 0.5% by FY2022-23 (Public Accounts definition). The plan appears credible. The macroeconomic assumptions underpinning the outlook are conservative, and the budget performance over the first four months of this fiscal year is proceeding broadly as planned.

Canada’s public sector balance sheet compares favorably to other highly-rated economies. While gross general government debt is high at 90% of GDP, the public sector holds substantial financial assets. On a net basis, Canada’s debt burden is low at 28% of GDP in 2017. Furthermore, public debt ratios are expected to decline over the next five years. With a strong public balance sheet and substantial financing flexibility, Canada has fiscal space to provide temporary support to the economy if downside risks materialize without putting stress on the ratings.

The Growth Outlook is Constrained by Ageing Demographics and Underperforming Labor Productivity

As the cyclical tailwinds lose strength, growth is expected to decelerate to the economy’s potential growth rate. Output is set to grow 1.7% per year on average from 2020 to 2023. 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 the share of working age people relative to the population is declining. However, structural factors also appear to be impeding higher growth. This is reflected in Canada’s labor productivity performance, which has lagged other advanced economies over the last three decades. Government efforts to raise potential growth and improve international competitiveness include increasing infrastructure investment and promoting research and development.

Risks to the economic outlook largely stem from the external environment. The potential escalation of U.S.-China trade tensions could adversely affect Canada through weaker global demand. In addition, global financing conditions could sharply tighten, perhaps on the back of strong U.S. growth and rising inflation, thereby raising borrowing costs for Canadian firms and households.

The Housing Market is Cooling but High Household Debt Remains a Vulnerability

The housing market is responding to rising interest rates and tighter macroprudential measures. While the rapid increase in housing prices in the Toronto and Vancouver areas over the last three years has led to concerns that prices are above levels consistent with fundamentals, both markets appear to be cooling. Resale activity has moderated and housing prices are stabilizing. Nevertheless, durably addressing affordability concerns will likely depend on an adequate supply side response.

The key domestic vulnerability is high household debt. From 2001 to 2017, household debt as a share of disposable income increased from 109% to 172%. Repayment capacity so far has been supported by low interest rates. However, interest rates are now rising, and house prices in some markets appear vulnerable to a correction. In this context, high household indebtedness could amplify negative shocks by forcing borrowers, particularly those with limited savings, to pull back on consumption and investment amid declining net wealth and tighter financing conditions. While the wave of household debt appears to be cresting as credit growth slows, the vulnerability related to the stock of debt will likely remain over the medium term.

An adverse shock in the context of high household indebtedness could lead to increased credit costs for Canadian banks, but several factors support the resilience of the financial system. Mortgage insurance rules and lending standards have been incrementally tightened over the last decade to contain risks of deteriorating asset quality. Almost half of the outstanding mortgage balance was insured at origination or through portfolio insurance. Those mortgages that are uninsured have loan-to-value ratios below 80%, which provides banks with greater protection. Furthermore, Canadian banks are well-capitalized and highly profitable, which puts them in a strong position to absorb greater provisioning related to home lending, if necessary.

Canada’s External Accounts Do Not Exhibit Any Clear Imbalances

The current account deficit declined marginally to 2.9% of GDP in 2017. The deficit is expected to narrow over the medium term as investment stabilizes and domestic savings gradually increase. Exchange rate flexibility should help the economy adjust to evolving global conditions. Despite moderate current account deficits over the last five years, Canada has shifted from a net liability position to a net asset position, as external assets have benefited from buoyant global markets and local currency depreciation.

Canada Benefits from Strong Public Institutions

Canada is a stable liberal democracy with effective public institutions. The country is characterized by strong rule of law, a sound regulatory environment, and low levels of corruption. According to the World Bank’s Worldwide Governance Indicators, Canada ranks highly compared to other advanced economies in all areas of measured governance. The next federal election is scheduled to take place by October 2019. It is premature to assess the outlook or potential results. Nevertheless, DBRS believes that there is a consensus among the three main parties on the need for responsible fiscal management.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the AAA – AA (high) range. The main points discussed during the Rating Committee include cyclical developments in the domestic economy, housing market dynamics, household balance sheets and the banking system, and the external environment.

KEY INDICATORS

Fiscal Balance (% GDP): -1.1% (2017); -1.2% (2018F); -1.1% (2019F)
Gross Debt (% GDP): 89.7 (2017); 87.3 (2018F); 84.7 (2019F)
Nominal GDP (Can$ billions): 2,145 (2017); 2,239 (2018F); 2,336 (2019F)
GDP per capita (Can$ thousands): 58.5 (2017); 60.3 (2018F); 62.3 (2019F)
Real GDP growth (%): 3.0 (2017); 2.1 (2018F); 2.0 (2019F)
Consumer Price Inflation (%, eop): 1.6 (2017); 2.5 (2018F); 2.2 (2019F)
Domestic credit (% GDP): 194.0 (2017); 194.8 (June-2018)
Current Account (% GDP): -2.9 (2017); -2.9 (2018F); 2.0 (2019F)
International Investment Position (% GDP): 20.2 (2017); 23.7 (June-2018)
Gross External Debt (% GDP): 115.2 (2017); 115.9 (June-2018)
Governance Indicator (percentile rank): 96.3 (2017)
Human Development Index: 0.926 (2017)

Notes:

All figures are in Canadian dollars unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/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 at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include Department of Finance, Bank of Canada, Statistics Canada, IMF, UNDP, World Bank, NRGI, Brookings, BIS, World Economic Forum, The Conference Board Total Economy Database-March 2018, Federal Reserve Bank of Dallas, The Canadian Real Estate Association, JPMorgan, and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be 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 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 European Union.

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

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: Michael Heydt, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer – Global FIG and Sovereign Ratings
Initial Rating Date: October 16, 1987
Last Rating Date: October 13, 2017

Information regarding DBRS ratings, including definitions, policies and methodologies, is available on www.dbrs.com.