DBRS, Inc. (DBRS Morningstar) confirmed the Government of Canada’s Long-Term Foreign and Local Currency – Issuer Ratings at AAA. At the same time, DBRS Morningstar 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 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 DBRS Morningstar’s view that Canada’s credit profile remains strong despite the economic and health impact of the pandemic as well as the escalating geopolitical tensions.
The Canadian economy recovered strongly in the second half of 2021. Output returned to pre-pandemic levels in the fourth quarter and the labor market tightened considerably on the back of robust job gains. Activity may have slowed in early 2022 due to the Omicron variant, but we expect the impact to be mild and short-lived given that new COVID-19 cases were sharply down by February and most provinces have already lifted restrictions. Pent-up demand, consumers’ deployment of excess savings, and gradually easing supply constraints underpin expectations of a relatively positive near-term outlook. The IMF projects GDP growth of 4.1% in 2022 and 2.8% in 2023. The government is starting to withdraw policy accommodation as various indicators point to little or no slack in the economy. Policy tightening should moderate aggregate demand, reduce inflation pressures, and potentially help to cool a red-hot housing market.
Some public finance metrics have deteriorated as a result of the extraordinary policy stimulus delivered during the pandemic. Gross general government debt is estimated to be 23 percentage points of GDP higher in 2021 than in 2019. However, the economic recovery and the withdrawal of fiscal support bode well for public finances. The federal fiscal deficit is expected to decline from 14.6% of GDP in FY20/21 to just 2.2% in FY22/23. Recently announced budget results also point to a significant improvement at the provincial level. Going forward, we expect the government debt ratio to be on a firm downward trajectory.
Notwithstanding the positive outlook, risks in the near term are skewed to the downside, in our view. The pandemic could continue to disrupt supply and weigh on the recovery. In addition, the conflict in Ukraine adds considerable risk to the global outlook. Canada may benefit from higher commodity export prices, but escalating geopolitical tensions could also materially weaken demand from key trading partners, worsen existing supply chain disruptions, and add to inflation pressures.
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.
Pandemic-Related Fiscal Support Is Being Removed As Activity Recovers
The federal fiscal deficit is quickly returning to a more sustainable position. According to the Economic and Fiscal Update (December 2021), the deficit is projected to narrow to 5.8% of GDP in FY21/22 and 2.2% in FY22/23. Based on data from the first nine months of the year, however, we expect the government to materially outperform the FY21/22 deficit target. The large and rapid improvement is being driven by higher revenues, which are benefiting from strong nominal GDP growth, and lower outlays as pandemic-related spending programs are being wound down. In later years, the deficit is projected to gradually narrow to 0.4% of GDP by FY26/27. However, the Update did not include proposals from the Liberals’ 2021 campaign platform in the outlook. In January 2022, the Parliamentary Budget Officer estimated that such measures would amount to $49 billion (1.9% of GDP) in net new spending over a five year period. This adds modest upside risk to the deficit trajectory. With the release of the 2022 budget in the coming weeks, we should get a better sense of the government’s fiscal objectives and strategy.
The large fiscal deficits combined with the 2020 recession led to markedly higher government debt. The IMF estimates that gross debt-to-GDP for the general government (i.e. federal plus provincial plus municipal governments) increased from 87% in 2019 to 110% in 2021. Notwithstanding the level increase, several factors support Canadian public finances. First, debt ratio is on a firm downward trajectory due to solid near-term growth prospects and the withdrawal of pandemic-related fiscal support. The IMF projects debt-to-GDP to decline to 104% in 2022 and down to 90% by 2026, which is close to the debt ratio prior to the pandemic. Second, debt servicing costs remain low despite the higher level of debt. This is the case even after taking into account higher borrowing costs going forward. The nominal yield on the 10-year government bond averaged 1.8% in the first two months of 2022, which is up roughly 50 basis points from the average of 2021, but still modest by historical standards.
Third, the government balance sheet was in relatively good shape going into the pandemic. Although Canada’s gross debt-to-GDP is high, the ratio is approximately 14 percentage points lower if you exclude accounts payable, which improves comparability across countries. Furthermore, 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. These two factors account for the one category uplift in the “Debt and Liquidity” building block assessment.
The Central Bank Is Withdrawing Monetary Stimulus Amid Broadening Inflationary Pressures
Inflation has accelerated in Canada amid supply constraints and strengthening demand. Annual headline inflation reached 5.1% in January 2022, the highest level in over 30 years. Rapidly rising food and energy prices account for nearly half of the increase but inflationary pressures are broadening, with services inflation and shelter inflation picking up. The average of the Bank of Canada’s preferred core inflation measures increased from 1.7% one year ago to 3.2% in January 2022. We expect inflation to peak in the first half of 2022 and then moderate in the second half of the year. The Bank of Canada is responding: it brought its QE program to an end in November 2021 (although the Bank continues to purchase roughly S1 billion per week in order to replace bonds as they mature so as to keep the nominal size of its Government of Canada bond holdings relatively stable) and raised the policy rate for the first time by 25 basis points in March 2022. Markets are pricing in about five to six more 25 basis point hikes this year, which would take the policy rate to 1.75% or 2.0%. Such actions would shift monetary policy to a more neutral stance by the end of the year.
Canada’s housing market is booming but rising rates should cool the market in 2022. Market activity has been hot since the second half of 2020, driven by very low mortgage rates and the shift in preferences toward lower density areas and more spacious homes. With rates starting to rise, the increase in sales activity over the last five months may be driven by homebuyers’ desire to pull forward purchases in order to take advantage of lower rates. In this context, prices have continued to climb, supported by limited inventory. However, sales and price growth should moderate this year as mortgage rates increase, affordability constraints tighten, and pandemic-related shifts in demand begin to ease. Over the longer term, efforts to address affordability problems in parts of the country will depend on the ability to increase the stock of housing.
High household indebtedness continues to be a vulnerability even as household balance sheets in aggregate have improved since the outbreak of the pandemic. Net disposable income actually increased 9% in 2020 as government support programs more than offset lost income, and rose another 3% over the first three quarters of 2021 (yoy) as labor markets recovered. With reduced spending options during the pandemic, households built up savings and paid down consumer debt. At the same time, buoyant equity and housing markets bolstered the asset side of the balance sheet. However, the high stock of debt may still end up causing financial stress for some borrowers, particularly lower-income and younger workers that typically have less savings set aside.
The banking system has withstood the pandemic remarkably well. The vast majority of households and businesses that deferred loan repayments at the outset of the pandemic have resumed making repayments. Last year, bank earnings and asset quality remained strong, benefitting from the government’s pandemic-related support programs and the country’s improving health and economic conditions. The large banks entered 2022 highly capitalized (although they are looking to deploy capital organically, through acquisitions, through share buybacks or some combination of the three). Several factors also 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. Furthermore, nearly one-third of outstanding mortgage balances were insured at origination or through portfolio insurance obtained by these banks. Of those mortgages that are uninsured, the loan-to-value ratios are below 80%, which provides banks with greater protection in the event of a housing price shock. Our assessment of the measures taken by authorities to reduce financial stability risks – and our view that some of the deterioration in credit and property price metrics from our scorecard are temporary – positively influences our “Monetary Policy and Financial Stability” building block assessment.
The Canadian Economy Is Expected To Grow At A Moderate Pace In The Post-Pandemic Period
The IMF projects the Canadian economy to grow by 1.6% 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 also appear to be impeding labor productivity growth, which has lagged other advanced economies over the last three decades. On a positive note, immigration appears to be recovering quickly from the pandemic lows and is set to contribute to robust population growth over the medium 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 shifted from deficit of 1.8% of GDP in 2020 to a surplus of 0.1% in 2021. The shift was driven by higher commodity export prices and lower travel services imports. Although Canada has run current account deficits for most of the last decade, the country’s net international asset position has increased as a share of GDP (56% of GDP in the third quarter of 2021). Canadians’ assets abroad have rapidly grown on the back of buoyant global equity markets as well as foreign currency appreciation.
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 World Bank’s Worldwide Governance Indicators, Canada ranks highly compared to other advanced economies across a range of governance measures. The Liberal Party returned to power following the September 2021 election with a minority mandate. As a result, the Liberals must seek out partners on a case-by-case basis to pass legislation.
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/393603.
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 https://www.dbrsmorningstar.com/research/381451/global-methodology-for-rating-sovereign-governments (July 9, 2021). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/dbrs-morningstarcriteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3, 2021).
Generally, the conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are monitored.
The primary sources of information used for this rating include the Department of Finance (Economic and Fiscal Update 2021), Bank of Canada (Monetary Policy Report, January 2022), Statistics Canada, Parliamentary Budget Officer (Economic and Fiscal Update 2021: Issues for Parliamentarians – January 19, 2022), IMF WEO (October 2021 & January 2022 Update), UN, World Bank, NRGI, Brookings, BIS, The Canadian Real Estate Association, Social Progress Imperative (Social Progress Index 2021), and Haver Analytics. DBRS Morningstar 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 for this rating action. DBRS Morningstar 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 United Kingdom, and by DBRS Ratings GmbH for use in the European Union, respectively. The following additional regulatory disclosures apply to endorsed ratings:
Each of the principal methodologies/principal asset class methodologies employed in the analysis addressed one or more particular risks or aspects of the rating and were factored into the rating decision, the “Global Methodology for Rating Sovereign Governments” (July 9, 2021) was utilized to evaluate the Issuer, and “DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings” (February 3, 2021) was used to assess ESG factors.
The last rating action on this issuer took place on September 22, 2021.
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 DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.
Lead Analyst: Michael Heydt, Senior Vice President, Credit Ratings
Rating Committee Chair: Thomas R. Torgerson, Managing Director, Credit Ratings
Initial Rating Date: October 16, 1987
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