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 the changing domestic political landscape and macroeconomic challenges, including the ongoing threat of U.S. tariffs.

The Canadian economy remains resilient, as domestic consumption has been supported by significant monetary policy easing and the labour market is showing signs of stabilizing following last year's rise in unemployment. Government actions to recalibrate immigration policy are having the intended effect, with slowing population growth contributing to a stabilization in both labour and housing markets, although housing affordability remains a concern despite the decline in interest rates. Notwithstanding the positive momentum, the threat of U.S. tariffs presents a material downside risk to growth and, even if Canada is ultimately successful at averting tariffs, the uncertain policy environment will dampen business investment. Additionally, the political landscape in Canada is changing as the governing Liberal Party is in the midst of selecting a new leader who will become the next Prime Minister, and a general election is likely to follow imminently with the polls suggesting a change in government is likely. The IMF projects GDP growth of 2.0% in 2025 as well as 2026, a forecast that is further susceptible to uncertainty in global trade policy which is having a chilling effect on investment.

While an uncertain macroeconomic and political environment cloud the outlook, Canadian public finances are generally sound. Gross general government debt is on a downward trend and forecast to approach pre-pandemic levels over the medium term. The general government deficit is expected to increase to 2.0% of GDP in 2024 compared to 0.6% in 2023, and then decline over the medium term.

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
Canada's Economy Resilient And Poised To Weather Tariff Threat

The IMF projects the Canadian economy to grow by 2.0% in 2025, up from 1.3% in 2024, and average 1.8% real growth over the ensuing four years. As inflation has subsided back to target rates, there has been a material reduction in interest rates which is favourable for domestic demand. However, slowing population growth will likely dampen headline growth as the government plans to reduce immigration through a reduction in permanent residents, temporary foreign workers, and international students (see Hitting the Reset Button: The Impact of Revised Immigration Policies in Australia and Canada, February 24, 2025). The threat of U.S. tariffs presents a material downside risk to the outlook. On February 1, 2025, the Trump administration announced tariffs of 25% on all imports from Canada (excluding energy which would be levied a 10% tariff), although this was subsequently postponed for one month (see U.S. Tariffs: Present Trump's Opening Salvo, February 4, 2025). Further incremental tariffs of 25% have been announced for steel and aluminum that would potentially take effect March 12, 2025. While it remains our expectation that blanket U.S. tariffs on Canada and Mexico will not be applied, the uncertainty itself will have a material negative impact on business investment is likely to weigh on broader economic activity in the near term.

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 0.7% of GDP in 2023 to 1.0% in 2024. 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 2024, the net asset position reached 66% 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.

Despite Changing Political Landscape, Strong Governing Institutions Underpin The AAA Ratings

On January 6, 2025, after mounting pressure from opposition parties and declining popularity, Prime Minister Justin Trudeau announced his intention to resign as leader of the Liberal Party as soon a new leader is chosen. The Liberal Party will select a new leader on March 9, 2025, with former Finance Minister, Chrystia Freeland, and former Bank of Canada Governor and Bank of England Governor, Mark Carney, positioned as the current frontrunners. The next federal election is scheduled for October 20, 2025, although there's a high likelihood that an earlier election will be triggered by either the incoming Liberal leader or through a vote of non-confidence by opposition parties. While the Conservative Party, led by Pierre Poilievre, continues to lead in the polls, support for the Liberal Party is increasing after Trudeau's resignation and the threat of U.S. tariffs on Canadian exports which has somewhat unified the country. While the upcoming election potentially represents a significant change in fiscal and economic policy direction, Canada's strong fiscal position and resilient economy, leave it well positioned to adjust to the changing political landscape.

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.

Canada's Modest Fiscal Deficits and Declining Debt Leave It Well Positioned to Weather Political and Economic Uncertainty

The Fall Economic Statement released in December 2024, projects an increase in the FY24-25 federal deficit to $48.3 billion (1.6% of GDP), from $39.8 billion at the time of the spring budget. While the medium-term plan still points to gradually declining deficits through FY2029-30, deficits are now larger each year of the plan. New measures that have incrementally added to the deficit include the just concluded two-month GST holiday ($1.6 billion), improving border security ($1.3 billion), and extending the accelerated investment incentive ($17.4 billion). While there has been clear erosion in the outlook because of new fiscal measures, the deficit is forecast to be less than 1.0% of GDP by FY2026-27, before falling to just 0.6% of GDP by FY2029-30, and compares favourably with other G7 countries. With a new Prime Minister to be selected shortly and a general election on the horizon, fiscal policy is subject to change but Canada is entering this period of uncertainty from a position of strength with ample flexibility to respond to unforeseen shocks.

The outlook for debt is unchanged from prior expectations. The gross general government debt ratio is high but is trending down. The IMF estimates that general government debt as a share of GDP declined from its peak of 118% in 2020 to 106% by 2024. The ratio is projected to decline to 103% in 2025 and then gradually decline to 96% 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.

Inflation Has Returned to Target Range Potentially Allowing BoC To Pause, While Housing Market Remains In Balance

Headline inflation has hovered around the Bank of Canada's (BoC) 2.0% target since September 2024. In January 2025, year-over-year (YOY) headline inflation was 1.9%, down from 3.4% a year earlier and well below the peak of 8.1% in June 2022. This result was helped by the two-month goods and services tax holiday which affected about 10% of the CPI basket. Excluding the impact of tax changes, inflation rose to 2.6% from 2.2% the previous month. Importantly, shelter costs continue to rise more slowly with rents rising by 6.3% YOY and mortgage interest costs by 10.2% YOY ¿ both down from the prior month.

The Bank of Canada (BoC) began its current easing cycle in June 2024 and has now lowered its policy rate by a cumulative 200bps. Following the most recent 25bps reduction on January 29, 2025, the policy rate now stands at 3.00%. The BoC noted that lower interest rates are providing a boost to the economy through higher consumption and housing market activity and excess supply is gradually being absorbed. Reduced immigration targets is working to slow population growth and will also weigh on potential growth. Modest further easing is anticipated through the remainder of 2025, although there is considerable uncertainty given the unpredictable U.S. policy environment. The next scheduled announcement is on March 12, 2024.

The Canadian housing market appears relatively balanced. The downward movement in mortgage rates has been has yet to reignite demand as lower international immigration takes hold. In January 2025, sales activity was down 3.3% relative to the prior month but up 2.9% YOY and is near the 10-year historical average. Prices remain relatively subdued, little changed over the past year, and still below the March 2022 peak. Over the past year, the government has taken steps to reduce the number of non-permanent residents, including temporary foreign workers and international students, along with reductions in the target for permanent residents. This is already having an impact on housing market activity, although the trends vary across regions with generally softer markets in Toronto and Vancouver due to the overhang of condo inventory while the Prairies, Maritimes, and Québec exhibit more robust activity. 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.

High household indebtedness remains a vulnerability. However, household balance sheets remain strong as buoyant equity markets bolstered the asset side of the balance sheet. Household credit market debt to disposable income declined for the sixth consecutive quarter in the third quarter of 2024, as income growth continues to exceed growth in credit liabilities. While the adjustment to higher interest rates is well underway and mortgage rates have moderated, there remain a portion of borrowers still subject to higher interest costs upon mortgage renewals in 2025 and 2026. 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. 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 shocks. 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.

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 Factors in Credit Ratings (August 13, 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://www.dbrsmorningstar.com/research/449162.

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 (July 15, 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.

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Lead Analyst: Travis Shaw, Senior Vice President, Sector Lead
Rating Committee Chair: Thomas R. Torgerson, Managing Director,
Initial Rating Date: October 16, 1987

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