DBRS Morningstar Confirms Government of Canada at AAA Stable

DBRS Limited (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 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 DBRS Morningstar’s view that Canada’s credit profile remains very strong despite ongoing macroeconomic challenges, including persistent inflation and high household indebtedness.

The Canadian economy continues to demonstrate resilience but momentum is slowing. Real GDP grew at an annualized pace of 2.6% (q/q) in the first quarter of 2023 before slowing to a contraction of 0.2% (q/q) in the second quarter. Household consumption continued to be supported by strong population growth and the prior accumulation of household savings. The labour market remains relatively tight but is showing signs of softening with the unemployment rate at 5.5% in July 2023, up from 4.9% a year earlier. The housing market continues to adjust to higher interest rates, but has moved beyond correction territory into a more balanced market. The IMF projects growth of 1.7% in 2023 before moderating to 1.4% in 2024. Following the latest economic readings, DBRS Morningstar believes there is potential downside risk to the current forecast.

While economic growth may be slowing, Canadian public finances have experienced a significant turnaround since the pandemic and the trajectory remains favourable. Gross general government debt is now firmly on a downward trend and expected to return to pre-pandemic levels over the medium term. The federal budget deficit is expected to come in around 1.4% of GDP in FY23/24, down from 11.4% in FY20/21, while fiscal results at the provincial level have also rapidly improved.

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
The Pace Of Improvement In Fiscal Accounts Has Slowed But Remain In A Sustainable Position

The federal fiscal deficit continues to decline. According to the FY23-24 budget, the federal deficit is expected to decline to $40.1 billion, or 1.4% of GDP in FY23-24. While the pace of improvement is somewhat slower than projected in the November 2022 Fall Economic Statement (FES), it is largely consistent with DBRS Morningstar’s prior expectations. Early data from this fiscal year indicates that performance is on track with budget expectations as the federal government has posted a slight surplus in the first quarter of the year (April to June). The pace of revenue growth has slowed from the prior year, alongside expectations for weaker growth in nominal GDP, while increases in direct program expenses and transfers to others levels of government, along with higher debt-servicing costs drive spending higher. As a result, the pace of improvement in federal government finances is slowing. Over the medium-term, the budget projects that the deficit will gradually decline to 0.4% of GDP by FY27-28. With provincial budget results also steadily improving over the last year, the combined fiscal policy stance across the general government (i.e. federal plus provincial plus municipal governments) is in a sustainable position.

The government debt-to-GDP ratio is trending firmly downward from the Coronavirus pandemic high, but the pace of improvement is slowing. The IMF estimates that gross debt-to-GDP for the general government declined from 119% in 2020 to 107% by 2022. The ratio is projected to decline to 105% in 2023 and 91% by 2028, which, if achieved, would be close to pre-pandemic levels.

In the FY23-24 budget, the government announced that it was considering consolidating the Canada Mortgage Bond (CMB) program ($260 billion outstanding as of August 15, 2023) into the regular Government of Canada borrowing program. Should the consolidation proceed, this would result in an increase in the IMF’s measure of Canada’s general government gross debt, as CMBs are not presently captured. There would be no impact on general government net debt-to-GDP as the increase in liabilities would be offset by an increase in financial assets. In DBRS Morningstar’s view, this proposed change in financing approach and the resulting accounting impact would have no impact on the “Debt and Liquidity” building block assessment and overall ratings. The government expects to provide an update on its plans in the fall economic and fiscal update, with any potential changes beginning no earlier than FY24-25.

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 18 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 Canadian Economy Remains Resilient But Growth Is Slowing

The IMF projects the Canadian economy to grow by 1.7% in 2023, before moderating to 1.4% in 2024. While momentum has clearly slowed from the post-pandemic recovery, the economy continues to demonstrate resilience. The labour market remains strong, despite slowing consumption and rising interest rates. Canada has benefited from strong population growth, supported by government policy to increase immigration targets as well as a large influx of non-permanent residents. This has helped to mitigate the impacts of an otherwise ageing population and somewhat masks the impact of slowing economic activity.

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 narrowed from 2.2% of GDP in 2020 to 0.4% in 2022. The change was primarily driven by higher commodity export prices. However, the terms of trade deteriorated in the first half of 2023. Lower export prices resulted in Canada running its first quarterly goods deficit in two years. This was partially offset by a slightly narrower services deficit, as Canadians reduced travel to the United States. 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 2023, the net asset position reached 39% of GDP.

The Bank Of Canada Moves To The Sidelines Again And The Housing Market Continues To Adjust

After peaking at 8.1% in June 2022, inflation is showing signs of moderation. As of July 2023, headline inflation declined to 3.3% although this marked an uptick from 2.8% the prior month, and now exceeds headline inflation in the United States for the first time since before the pandemic. The acceleration in July was mainly due to a base-year effect in gasoline prices that experienced a large decline in July 2022. Rising mortgage interest costs are a key contributor to headline inflation, rising 30.6% YOY. Additionally, food price inflation remains elevated, rising by 8.5% YOY, although this pace has slowed from the prior month.

Following a brief pause through March 2023 and April 2023, the Bank of Canada resumed its monetary tightening cycle with 25 basis point increases in both June and July. Since March 2022, the target for the overnight rate has risen by a cumulative 475 basis points. Furthermore, quantitative tightening, which began in April 2022, continues as the Bank of Canada allows its holdings of government bonds to run off its balance sheet as the bonds mature. On September 6, 2023, the Bank of Canada maintained the policy rate at 5.0% but reiterated its willingness to raise interest rates further should inflation persist. The Bank of Canada continues to balance the anticipated lagged impact of earlier rate hikes with the persistence of excess demand that continues to percolate through strong labour markets, and a pickup in housing market activity.

The Canadian housing market continues to adjust to the rapid increase in interest rates and affordability constraints. After finding a floor early in the year, both sales and prices have picked up. Sales activity has picked up from the start of the year, with nationwide sales up 21%, although this is still 37% below the peak reached in March 2021. Similarly, prices are up 8% from January through July 2023, though still down 12% compared to the March 2022 peak. The market appears to be in a generally balanced position with sales to new listings hovering near the ten-year average, though risks are tilted to the upside. Absent a moderation in population growth, new housing supply is unlikely to keep up with demand. Regionally, Calgary has bucked the national trend, with sales volumes and prices running hotter than elsewhere, though this largely reflects a catchup from challenging local market conditions that persisted prior to the pandemic-induced acceleration in activity across other markets. Prices are expected to stabilize through the remainder of the year as the impact of prior rate hikes weighs against sturdy demand stemming from still solid population growth.

High household indebtedness remains a vulnerability as borrowing costs increase. Household net disposable income increased 4% in 2021, and 5% in 2022 as labour markets remained strong. With reduced spending options during the pandemic, households built up savings and paid down consumer debt. Buoyant equity and housing markets further bolstered the asset side of the balance sheet although these have moderated of late. Household debt levels remain high, and with interest rates now elevated, 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 in the last two years and have less savings set aside.

Canadian banks are relatively well-positioned to weather an adjustment in the housing market. Several factors 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. Nearly one-third of outstanding mortgage balances were insured at origination or through portfolio insurance obtained by the banks. Of those mortgages that are uninsured, the loan-to-value ratios are below 80%, which provides banks with greater protection to a housing price shock. In addition, the large banks entered 2023 highly capitalized (although they are looking to deploy capital organically, through acquisitions, through share buybacks or some combination of the three).

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 returned to power with a minority mandate following the September 2021 election. Six months later, the Liberals reached 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, the NDP agreed to support the Liberals in confidence and budget votes through 2025, when the next federal election is scheduled to take place.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
There were no Environmental, Social, Governance factors that had a significant or relevant effect on the credit analysis.

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/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (July 4, 2023).

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/420369.

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 https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments (August 29, 2022). In addition DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (July 4, 2023) in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

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 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 www.dbrsmorningstar.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.

DBRS Morningstar 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.

This credit 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 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 DBRS Morningstar 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 DBRS Morningstar 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, Credit Ratings
Rating Committee Chair: Thomas R. Torgerson, Managing Director, Credit Ratings
Initial Rating Date: October 16, 1987

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.

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