Fitch Affirms Canada at 'AAA'; Outlook Stable

NEW YORK--()--Fitch Ratings has affirmed Canada's Long-Term Foreign and Local currency Issuer Default Ratings (IDRs) at 'AAA' with a Stable Outlook. Fitch has also affirmed the issue ratings on Canada's senior unsecured Foreign- and Local-Currency bonds at 'AAA'. The Ratings Outlooks on the Long-Term IDRs are Stable. Fitch has affirmed the Country Ceiling at 'AAA' and the Short-Term Foreign Currency and Short-Term Local Currency IDRs at 'F1+'.

KEY RATING DRIVERS

Canada's 'AAA' rating draws support from its advanced, well diversified and high income economy. Its political stability, strong governance and institutional strengths support the rating. Its overall policy framework remains strong and has delivered steady growth and low inflation.

Slower GDP growth, the impact of lower oil prices on national income, and a fiscal stimulus package have caused the fiscal outlook to deteriorate relative to our last review. Steep cutbacks to energy investment led to two consecutive quarters of negative growth in 1H15 and limited nominal GDP growth to just 0.5% in 2015, although the brunt of the shock was borne by energy-producing provinces and private consumption was little affected at the national level.

The Trudeau government which took office in November 2015 will increase government spending to mitigate the economic impact of the oil price fall, supporting lower-income Canadians and spending more on infrastructure. This will lead to higher growth in the short-run although the long-term effectiveness of the programme will depend on the value of the projects financed.

The federal budget deficit will start to narrow again in 2017/18. This assumes that the spending boost is unwound as spelled out in the budget. The overall general government deficit, which includes the provinces, will rise from 1.3% of GDP in FY2015/16 to 2.5% of GDP in 2016/17, but Fitch expects it to improve thereafter as the federal deficit peaks and the provinces make progress reducing their deficits.

The general government debt ratio was already rising before the budget plans were unveiled, and larger federal deficits mean economic shocks or growth underperformance would be more likely to undermine Canada's debt trajectory. Gross general government debt is the second highest among 'AAA' countries and jumped by 5pp of GDP to 91.5% of GDP in 2015, reflecting a combination of below-the-line stock-flow adjustments and currency depreciation. Federal government debt is 33% of GDP and on a stable to falling path over the medium-term despite the stimulus.

Uniquely among highly-rated sovereigns, two-thirds of GG debt is issued by subnationals (provinces). In contrast to the federal government debt, provincial debt appears to be on a long-term increasing trend, which could put upward pressure on the broader public sector balance sheet if not off-set by declines at the federal level. Of the two largest provincial debtors, Ontario ('AA-'/Outlook Stable) narrowed its deficit to 0.8% of GDP in 2015 and Quebec ('AA-'/Outlook Stable) has balanced its budget. Resource-dependent Alberta will run sizeable deficits following the oil price shock, but has little debt. Canada's unfunded pension liability is lower than peers. Savings in pension funds build up household assets, while reducing government contingent liabilities.

Fitch expects Canada's real GDP to grow 1.3% in 2016, and 2.1% in 2017 when the impact of higher government spending peaks. Growth in the labour force is set to fall, limiting potential growth to below 2%. The Bank of Canada, which cut its policy rate by 50bps to 0.5% in 2015, will maintain an accommodative policy stance, even if the Federal Reserve raises rates.

Fitch notes risks associated with a buildup of household debt and a steep rise in property prices. Household debt as a share of disposable income is high but relatively stable at 165%, and is matched by other highly-rated sovereigns. The debt service burden is 14% of income, stable for the past three years, but would increase if interest rates rise and could become less sustainable in the event of a recession. A steep fall in house prices - not Fitch's base case - would pose some economic and financial stability risks and would exacerbate any future economic downturn via its impact on household wealth.

Several rounds of macroprudential policy tightening have aimed to cool the property market. The rate at which property prices are increasing has risen from an average of 5% in 2015 to an average of 7.7% in the first half of 2016, driven by hotspots including Vancouver and Toronto. Among the major housing markets tracked by Fitch, Canada is an outlier in terms of the rise in property prices over the past decade. 55% of all mortgage debt is insured by the government-backed Canada Mortgage and Housing Corporation (CMHC), transferring part of the risks from mortgage lending from the banks to the state.

CMHC stress tests show that it could withstand a U.S.-style (30% peak to trough) fall in property prices without requiring additional capital and could continue to assure the flow of mortgage credit. Fitch's Banking System Indicator for Canada, a measure of the standalone strength of the banking system, is 'aa', on par with the strongest global peers.

SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)

Fitch's proprietary SRM assigns Canada a score equivalent to a rating of 'AA' on the Long-term FC IDR scale.

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:

--Public Finances: +1 notch, to reflect mitigants to the high general government debt/GDP ratio, including high share of debt at provincial level, more advantageous net debt position, small unfunded pension liability relative to peers.

--External finances: +1 notch, to reflect external financing flexibility, resilience of current account despite commodity exposure, strengthening net IIP (including equity).

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

RATING SENSITIVITIES

The following factors would be negative for the rating:

--Increasing risk of housing market or financial sector stress that could lead to economic underperformance and fiscal costs for the sovereign;

--Increasing debt burden at federal or provincial level that increases vulnerability of the general government balance sheet.

KEY ASSUMPTIONS

Fitch assumes that Brent averages USD42/b in 2016, USD45/b in 2017 and USD55/b in 2018.

Fitch assumes that U.S. real GDP grows 1.8% in 2016, 2% in 2017 and 2.2% in 2018.

Fitch estimates that property prices are 20% overvalued nationally but that the property market will avoid a hard landing.

Additional information is available on www.fitchratings.com

Applicable Criteria

Country Ceilings (pub. 20 Aug 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869287

Sovereign Rating Criteria (pub. 18 Jul 2016)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=885219

Additional Disclosures

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https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1009885

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1009885

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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Contacts

Fitch Ratings
Primary Analyst
Charles Seville
Senior Director
+1-212-908-0277
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Todd Martinez
Associate Director
+1-212-908-0897
or
Committee Chairperson
Tony Stringer
Managing Director
+44 20 3530 1219
or
Media Relations:
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Charles Seville
Senior Director
+1-212-908-0277
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Todd Martinez
Associate Director
+1-212-908-0897
or
Committee Chairperson
Tony Stringer
Managing Director
+44 20 3530 1219
or
Media Relations:
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com