S&P Global Ratings' 'AAA' rating places Canada in an exclusive group of sovereigns. Of the 136 sovereign governments that we rate as of June 30, 2021, only 11 are in the 'AAA' category, which is our highest rating. The group of sovereigns rated 'AAA' has shrunk over time; almost a decade ago, 16 sovereigns were rated 'AAA' (table 1).

Table 1

Canada Entered The COVID-19 Pandemic From A Position Of Credit Strength

Strong institutions and a track record of sustainable public finances lend credibility to the federal government's plan to wind down spending, and underpinned our recent decision to affirm our 'AAA' rating on Canada (see "Canada Ratings Affirmed at ‘AAA/A-1+'; Outlook Remains Stable," published April 26, 2021, on RatingsDirect). Canada used its considerable fiscal and monetary policy flexibility to respond to the COVID-19 pandemic. The general government (which includes the federal government, the provinces, municipalities, and social security programs) ran fiscal surpluses in four of the previous five years, and ran an almost balanced position, on average, in the 15 years preceding the pandemic. As a result of the pandemic, Canada will likely run the largest increase in net general government (GG) debt among all 'AAA' rated sovereigns in 2020 and 2021. However, Canada entered the pandemic with lower net GG debt levels to GDP than two other 'AAA' rated sovereigns, Germany and the Netherlands, which have among the largest economies of the 'AAA' group, similar to Canada (chart 1).

Chart 1

Despite Canada's debt-financed spending response to the pandemic, we think that the rating will remain well positioned in the 'AAA' category over the forecast horizon. One of the key reasons for this is Canada's strong institutional and economic profile, which is composed of the two assessments that carry about half the weight under our sovereign methodology for arriving at an indicative rating (see chart 2). Although all 'AAA' rated sovereigns carry the strongest economic assessment--rooted in high per capita income levels--Canada is one of seven that also carry the strongest institutional assessment. Canada has a history of good governance, stable parliamentary democracy, rule of law, a low perception of corruption, and a cohesive society. It also has not had a major anti-establishment political movement in the recent past, and the population has generally been supportive of the broad contours of the government's response to the recent economic downturns. Unlike in several other 'AAA' rated sovereigns that must coordinate their policies within a monetary union, Canada's central bank can design its policy directly to manage domestic economic conditions. The Canadian government has also used this flexibility in designing its sizable and timely response to the pandemic in order to mitigate economic volatility.

Chart 2

The strength, credibility, and independence of Canada's monetary policy also factor significantly in determining the 'AAA' rating and position the country as one of five 'AAA' rated sovereigns that carry the strongest monetary assessment (see chart 3). Canada also has an actively traded, free-floating currency and deep domestic financial markets. The Canadian dollar accounts for 5% of global foreign-exchange turnover and has the sixth highest turnover in the world, according to the most recent triennial central bank survey published by the Bank of International Settlements.

Canada's history of low and stable inflation, and policy transparency and predictability facilitate the government's access to funding and sustain investor confidence. Such favorable market perceptions minimized the risk of the Bank of Canada's decision to launch its first quantitative easing (QE) program at the start of the pandemic. Between April 1, 2020, and March 31, 2021, the central bank's holdings of Government of Canada bonds increased by about C$274 billion, which represents about 87% of the federal government's estimated 2020-2021 budgetary deficit. At the same time, at its current pace of purchasing about C$3 billion worth of government bonds per week, the bank could purchase a sum equal to the entirety of the federal government's projected 2021-2022 fiscal deficit in Government of Canada bonds. Nevertheless, we do expect a quantitative easing reduction, to purchases of C$2 billion per week from the current pace of C$3 billion, to take place at the bank's September 2021 meeting (see "Economic Outlook Canada Q3 2021: Growth Setback In The Spring Will Give Way to Summer Boom," Jun 25, 2021). At the same time, although the size of the increase in the central bank's holdings of federal government debt was higher than that of some peers, the value of these assets relative to the size of the Canadian economy is still fairly low, partially because the bank didn't have a QE program at the start of the pandemic.

Chart 3

Having an actively traded currency also makes Canada's external profile less vulnerable to shifts in foreign investment, while the country's large stock of external assets contributes to a better net external debt position than that of some of the larger 'AAA' rated sovereigns, such as Australia and the Netherlands. This, in part, reflects Canada's well-run pension funds and other financial institutions, plus a substantial stock of foreign direct investment held abroad. At the same time, unlike in Australia, where banks are materially reliant on offshore wholesale funding, Canadian banks are net external creditors, making them less exposed to external vulnerabilities. Canada's external asset position strengthened during the pandemic, in part due to valuation effects on external assets. Historically, about two-thirds of Canada's external assets have been denominated in U.S. dollars, while most of its external liabilities are denominated in Canadian dollars. Therefore, the negative impact of periodic adverse changes in Canada's terms of trade (price of exports divided by price of imports) has been buffered by an increase in the value of its external financial assets (as measured in Canadian currency) as the country's currency depreciated. At the same time, Canada's net international asset position strengthened in 2020, in part due to the equity composition of its external assets versus its liabilities. A much larger share of Canada's external assets (more than 70%) is held in the form of equities than its external liabilities (less than 40%).Therefore, changes in stock market conditions, which improved in key external markets by the end of 2020, affect Canada's external assets more than its liabilities.

Chart 4

Canada's favorable institutional, economic, monetary, and external assessments collectively weigh more heavily under our sovereign methodology in determining our rating than its less favorable fiscal assessment (which includes its debt burden). However, Canada's GG net debt will likely remain a rating weakness. Based on our forecast, Canada could have the highest net debt-to-GDP levels among all 'AAA' rated sovereigns by the end of 2024.

This higher GG debt burden can, in part, be attributed to the debt levels of the provinces, which are consolidated in our analysis of the sovereign's debt metrics. Before the pandemic, indebtedness of local and regional governments (LRGs; largely provinces) accounted for about two-thirds of Canada's net GG debt. In contrast with most sovereigns, the subnational governments of Canada have higher debt than the sovereign, reflecting the country's decentralized nature. However, since the federal government has funded about 80% of total fiscal support provided by all governments in Canada to respond to the pandemic, we expect the share of net central government (CG) debt will rise to more than 50% of net GG debt this year from about one-third in 2019(chart 5). The high level of LRG debt in Canada, and subsequently lower share of net CG debt as a share of net GG debt, is an outlier compared with most other 'AAA' rated sovereigns, and is most comparable with Germany. In Germany's case, net CG debt represents about 60% of net GG debt, and we expect this ratio will remain stable over the forecast horizon.

Canada's 10 provinces have considerable economic and constitutional capacity to manage their own finances, compared with their counterparts in other countries. They are responsible for education; health care; public security; and infrastructure such as roads and electricity. Subnational governments, including municipalities, account for most of Canada's public sector capital spending (including about 85% of infrastructure spending). With higher debt levels and lower ratings, provinces also have higher borrowing costs than the federal government.

Chart 5

Looking Ahead

Canada remains well positioned within the 'AAA' rated sovereign group, which was reflected in our recent rating action. The country's credit strengths, both within and outside its peer group, more than offset its weakened fiscal and debt position, in our view.

We have a stable outlook on our rating on Canada. We expect real GDP will recover sharply this year, surpassing 2019 levels, and increase by an unprecedented 6.1% as daily coronavirus caseloads remain far below previous peaks, provinces lift restrictions, and vaccinations roll out at an impressive pace. We continue to assume that a "full-vaccine" economy will materialize in late summer and believe that these conditions will set the stage for a strong rebound in demand as the summer progresses (see "Economic Outlook Canada Q3 2021: Growth Setback In The Spring Will Give Way to Summer Boom," June 25, 2021). We expect that this recovery will lead to an improvement in the government's fiscal deficit over the next several years. However, future fiscal performance and policy signals will be important indicators that we will monitor. As we highlighted in our most recent research update, we could lower our rating on Canada in the next two years if the government's weakened fiscal position persists without signals of future corrective actions, and should this be accompanied by unexpectedly poor economic performance or substantial and sustained weakening in Canada's net external position, which would signal rising external vulnerabilities. While we have recently raised our Canadian economic growth outlook and believe that risks to our forecasts are largely balanced, a new rise in coronavirus cases and a new round of restrictions could negatively impact consumer spending and GDP growth, and present downside risks to our growth outlook. The evolution of the economic recovery will be key to the government's fiscal consolidation plans and supporting the government's higher debt burden over the next two years.