Fitch Downgrades Province of Ontario, Canada to 'AA-' from 'AA'; Outlook Revised to Stable

NEW YORK--()--Fitch Ratings has downgraded the following ratings for the Province of Ontario, Canada (the province) in the course of routine surveillance:

--Long-term Issuer Default Rating (IDR) to 'AA-' from 'AA';

--Long-term local currency IDR to 'AA-' from 'AA'.

The Short-term IDR rating has been affirmed at 'F1+'.

The Rating Outlook has been revised to Stable from Negative.

SECURITY

The bonds are senior unsecured obligations of the province to which the province's full faith and credit is pledged. Commercial paper notes are promissory notes ranking equally with Ontario's other unsubordinated and unsecured indebtedness.

KEY RATING DRIVERS

RATING DOWNGRADE: Difficult actions will be necessary to achieve the province's deficit elimination goal of fiscal 2018 and budget options are likely to prove more limited given the extent of actions taken to date and use of one-time actions to achieve targets, in Fitch's opinion. While the province is considering other fiscal options for fiscal 2016 should economic conditions restrain future revenue growth, the downgrade to 'AA-' reflects Fitch's concern that risks remain to achieving its goals and both debt burden and the accumulated deficit will remain significantly elevated, reflected in a rating level more consistent with an 'AA-' rating.

FISCAL 2015 BUDGET INCREASES DEFICIT: The projected increase in the operating deficit for fiscal 2015 results from more robust expenditure growth versus the province's current revenue expectations. This would be the second consecutive year-over-year increase in the province's annual deficit, but the first year with results underperforming the 2010 budget plan targets. Although Fitch believes there is the potential that actual results will be better than the current forecast, a planned deficit increase to a level above the plan articulated in the 2010 budget is a negative credit factor, particularly with the planned use of one-time measures, and offsets some of the otherwise positive financial progress made in recent years.

PROGRESS ON FINANCIAL PLAN IMPLEMENTATION: The province made positive progress through fiscal 2014 in exceeding the targets of a multiyear financial consolidation plan to achieve fiscal balance by fiscal 2018. The province has demonstrated the ability to exert considerable, ongoing expenditure restraint while instituting revenue changes as necessary to achieve its deficit reduction objectives, pointing to the strength of provincial management.

SIGNIFICANT FINANCIAL IMBALANCE: The province had an accumulated deficit equal to 152% of operating revenues in fiscal 2014 (25.4% of gross domestic product [GDP]) due to, slow revenue growth, and increasing expenditures, and sizable capital borrowing. Annual deficits through the forecast period of fiscal 2018 will contribute to growth in the accumulated deficit.

SIZABLE, DIVERSE ECONOMY: The province's diverse economy includes Canada's largest business and financial hub and accounts for 39% of the country's population. Sizable concentration remains in the large, cyclical manufacturing industry, although it has been offset in recent years by positive growth in trade, financial services, and education and health care services, diversifying the economic base. The provincial economy remains heavily linked to that of the U.S.

LARGE AND GROWING DEBT BURDEN: The province has a high debt burden (net direct debt to GDP) with net debt to GDP at 38.4% for fiscal 2014, although debt service expense is a manageable 8% of annual expenditures. Fitch expects debt levels to increase through fiscal 2016, and then begin to decrease, given the province's expectation of an annual deficit through that fiscal year and continued growth in GDP. Pensions are well funded.

RATING SENSITIVITIES

The rating is sensitive to the province's commitment and success in achieving deficit elimination targets and restoring fiscal balance. Failure to enact budgets that follow a path toward articulated deficit elimination targets would result in negative rating pressure. Reaching deficit elimination targets ahead of forecast, sizable growth in GDP, and steady progress on lowering debt burden and the accumulated deficit would be positive credit factors.

CREDIT PROFILE

Ontario's 'AA-' rating is supported by its wealthy, diversified economy and generally sound financial management. The province is making a slow recovery from the recession that subdued its economic growth, slowed its tax revenues, and resulted in increased debt levels as it funded a multi-billion-dollar economic stimulus program. The province's participation in the joint Canada-U.S. bankruptcy settlement with Chrysler and General Motors (GM) contributed notably to these escalating debt levels and operating deficits.

The province has made steady, positive progress through fiscal 2014 in implementing its financial plan to return to fiscal balance in fiscal 2018 largely through expenditure restraint aided by modest revenue measures and a stabilizing economy. Although Fitch notes that near-term budget goals have been exceeded, full fiscal recovery remains several years away after an increased annual operating deficit in fiscal 2014 and a projected second year of increased annual operating deficit in fiscal 2015, and will require sustained economic and revenue growth together with continued control over provincial expenditures, factors that underscore the rating revision to 'AA-'. Fitch believes that the province will also be challenged in restraining ongoing capital spending to make progress in lowering the high debt burden and accumulated deficit over time.

LARGE, DIVERSE ECONOMIC BASE

The province is Canada's largest by population, and its diverse economy generates 37% of Canada's GDP. Provincial GDP gains have been steady since the recession but trail national averages; GDP growth of 1.3% compared to Canada's 2% in 2013. Motor vehicles and parts, which were severely affected in the recession, account for a still sizable 34% of provincial international goods exports and declined by 0.7% in 2013, although strong 6.7% year over year (yoy) growth has been exhibited in 2014 through December 10. The manufacturing industry as a whole has markedly declined as a contributor to provincial real GDP (12.8% of provincial GDP [chained 2007 dollars] in 2013, down from 20.3% in 2000) reflecting both the declines in this industry as well as solid growth in trade, transportation, financial activities, and education and health services.

The broader economy of Ontario, and that of the nation, has evidenced continued slow improvement since the downturn, with yoy job gains in November 2014 of 0.8% and 0.9%, respectively. Results across all sectors are mixed, with finance, insurance, real estate and leasing (up 7.4%) as well as accommodation and food services (also up 7.4%) experiencing the largest employment gains. These gains were offset by losses in transportation and warehousing (down 8.2%), other services (down 9.5%), and business, building and other support services (down 3.4%). November 2014 unemployment in Ontario was 7%; down from 7.3% recorded a year earlier, while remaining above the national rate of 6.6%.

The province continues to actively manage its revenue assumptions in the context of changes in its economic forecast. The current economic and revenue forecast, released on November 17, 2014, moderates the forecasted growth pace of GDP that was included in the 2014 budget to reflect slower economic momentum. GDP growth in 2014 is now expected to be 1.9% (down from 2.1% in the prior forecast) and for 2015, GDP growth is estimated at 2.4%. Fitch believes there is upside potential to the economic forecast. The fall fiscal review also included a C$509 million negative revision in the province's revenue growth assumption for fiscal 2015. The negative revision is offset by a forecast for expenditures that has declined by C$208 million and by reducing the reserve by C$300 million.

MIXED PROGRESS ON FINANCIAL PLAN IMPLEMENTATION

The economic slowdown brought to an abrupt halt a multi-year period of balanced operations as the province boosted its spending for stimulus programs and approved a one-time, C$3 billion loan to GM and Chrysler in fiscal 2010. Fiscal 2010 ended with a C$19.3 billion operating deficit (20% of revenues) and the accumulated financial deficit grew to almost C$131 billion (137% of revenues). The province subsequently enacted its multiyear budget-balance plan in fiscal 2011 with the goal of improving its operating margins and reaching a balanced budget by fiscal 2018. To date, Fitch notes that the province has exceeded the targets as expressed in the plan while facing the challenge of slower GDP growth than originally forecast, requiring additional revenue and expenditure measures to achieve its annual goals.

For fiscal years 2011 and 2012, progress was made by exercising spending restraint and implementing operating efficiencies in key program areas and the annual operating deficits were reduced to C$14 billion and C$13 billion, respectively. A contributor to the fiscal 2012 results was the passage of a high income personal income tax (PIT) surcharge, continuing through fiscal 2018, to improve revenue results. The actual deficits in these years were an improvement upon the 2011 budget, which had forecast deficits of C$16.7 billion and C$16.3 billion in fiscals 2011 and 2012, respectively, and speak favorably to the province's expenditure controls and ability to institute revenue increases when necessary. The fiscal 2013 operating deficit was also an improvement from the 2011 budget; C$9.2 billion compared to C$15.2 billion, boosted by additional revenue growth and one-time items that increased revenues and lowered expenditures.

The C$10.5 billion operating deficit that was recorded for fiscal 2014, which ended on March 31, continued the trend of below-plan results (2011 budget target was a C$13.3 billion deficit) but was a larger deficit than the one recorded in fiscal 2013. Revenues were almost C$1 billion under budget; a factor of both prior period adjustments and lower tax revenues, even though adjustments were made to the PIT to increase collections. Expenditures increased by 3.1% from fiscal 2013. Overall revenues grew 2.2% from fiscal 2013 but revenues from taxation increased by only a modest 0.7%. The accumulated deficit grew to a large C$176.6 billion; equal to 152% of revenues that year.

For FY 2015, the province recently modestly lowered its revenue assumption (by C$509 million). Although this negative revision is offset by expenditures that are currently running below budget and application of C$300 million of reserve funds, Fitch is concerned that the province has planned for a second consecutive increase in the annual deficit this year, to C$12.5 billion and one-time actions in support of this target are likely to include the sale of provincial assets. In contrast to fiscal 2013, when the annual deficit was increased from the prior year but remained below the planned target, the current fiscal 2015 forecasted deficit is now above the planned target of C$10.7 billion for the year. Baseline revenue assumptions appear reasonable and include 5% growth in the PIT and 2.9% growth in sales tax revenue. Overall, revenues are forecast to grow 2.1% from fiscal 2014 while expenditures are budgeted to increase by 3%.

CHALLENGES TO PLAN EXECUTION; DEBT BURDEN WILL CONTINUE TO INCREASE

Despite the setback in the current fiscal year, the province continues to target fiscal 2018 as the year in which it will recover budget balance. The remaining years of the balancing plan continue to require the exercise of expenditure restraint and the province has prudently begun articulating the need to look at revenue options should economic conditions preclude required baseline revenue increases. Fitch believes expenditure targets will continue to be challenging to achieve. The province's current plans are for steady reductions in the annual deficit in fiscal years 2016 and 2017, but both year's projected deficits are above the 2010 targets.

Even if the province achieves its budget balance goal by fiscal 2018, it will be left with a sizable accumulated deficit and large debt burden that will have grown from current levels and is more consistent with a rating level of 'AA-'. The provincial goal is to bring the debt burden back down to 27% of GDP; given the current level of approximately 40%, Fitch believes that this is likely to prove challenging. A further substantial hurdle will be reducing the accumulated deficit which is currently forecast to increase to C$203 billion, equal to 26% of projected nominal GDP, in fiscal 2017.

SUBSTANTIAL BUT MANAGEABLE DEBT BURDEN

The province's debt burden has expanded greatly from financing its fiscal imbalances since the recession. Gross debt to GDP, including debt of consolidated entities and pension liabilities, was 42.5% in fiscal 2014, and is expected to grow under the current plan to approximately 43.1% in fiscal 2015. Net debt to GDP of 38.4% for fiscal 2014 is forecast to peak at 40.4% in fiscal 2016 before trending steadily downward. As noted above, the province has set a goal of bringing the debt burden to a more manageable 27% of GDP after fiscal 2018. Total borrowing in fiscal 2015 is forecast at approximately C$35 billion, of which C$10.2 billion is for capital purposes. Interest on outstanding debt remains manageable, at 8.4% of expenditures in FY 2014 and pensions are well funded.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Tax-Supported Rating Criteria' (Aug. 14, 2012);

--'International Local and Regional Governments Rating Criteria, Outside the United States' (April 23, 2014).

Applicable Criteria and Related Research:

Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686015

International Local and Regional Governments Rating Criteria - Outside the United States

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=719656

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=958755

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Contacts

Fitch Ratings
Primary Analyst
Marcy Block
Senior Director
+1-212-908-0239
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Douglas Offerman
Senior Director
+1-212-908-0889
or
Committee Chairperson
Laura Porter
Managing Director
+1-212-908-0575
or
Media Relations:
Elizabeth Fogerty, +1-212-908-0526 (New York)
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Marcy Block
Senior Director
+1-212-908-0239
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Douglas Offerman
Senior Director
+1-212-908-0889
or
Committee Chairperson
Laura Porter
Managing Director
+1-212-908-0575
or
Media Relations:
Elizabeth Fogerty, +1-212-908-0526 (New York)
elizabeth.fogerty@fitchratings.com