- KPB & Co Research
Canada, along with Germany, has been one of the few countries among the group of seven (G7) industrialized nations that can claim to have among the smallest health impact from the spread of COVID-19, yet it has been one of the first casualties of the resulting recession. On Wednesday, June 24, 2020, Fitch downgraded the debt of the Canadian government from AAA to AA+ (Outlook stable), citing concerns about the rising level of indebtedness of the government (federal & provincial). Canada is in the same "boat" as many other developed countries, in the sense that every country in the G7 has had to take on massive debt to counteract the negative effects of COVID-19. At the same time, Canada has far fewer per capita infection rates and death rates from the spread of COVID-19, than most other G7 nations thus far. Why then is the Canadian government the first to get a downgrade? It turns out that, according to the report provided by Fitch, Canada has several key vulnerabilities that pre-date the spread of COVID-19, vulnerabilities that are not present in other G7 nations, and that presents execution risks as the country navigates the murky waters ahead.
Higher Pre-Crisis Debt Levels
The sum total of Canada's provincial and federal government pre-crisis debt was significantly higher than the comparable ratio for the median 'AA' rated country. Fitch calculated that the country's consolidated gross general government debt was 88.3% of GDP in 2019 and will rise to 115.1% by the end 2020 due primarily to the coronavirus response. At the same time, the median 'AA' rated country is expected to stretch their debt levels to about 42.3% of GDP by the end of 2020. The interest/revenue ratio is expected to be 7.0% in 2020 versus 2.7% for the median 'AA' rated country. With such a huge gap between Canada's debt and that of the median 'AA' rated country it is surprising that the country wasn't already 'AA' rated.
With the annual gap between government revenues and expenses expected to expand from 1% of GDP in 2019 to 16.1% in 2020, then shrink to 6.5% and 3.0% of GDP in 2021 and 2022 respectively, there will likely be a debt momentum occurring at a time when growth in GDP is slow (more on this later). Furthermore, the decentralized nature of Canada's system of governance makes it challenging to embark on fiscal discipline at both the federal and provincial levels of government simultaneously. As such, there is a real risk that the downward trajectory assumed ends up being too optimistic. Fitch's baseline forecast is for consolidated gross general government debt/GDP ratio to stabilize at 120%-121% of GDP between 2022-2024.
Heavy Reliance on Foreign Money
Fitch calculates that approximately 20% of the provincial budget and a substantial amount of the federal budget are financed by foreign investors. The rating agency estimates that at the end of 2019 the amount of money the country owed to foreigners stood at 45% of GDP, which is substantially higher than that of the median 'AA' rated country (18.6% of GDP). Going forward, the rating agency feels that Canada will earn less from the global trade in goods and services, than what they will spend. This trade deficit was -2.0% of GDP in 2019 but is expected to average -3.6% between 2020 and 2022, indicating that the agency expects the country to continue borrowing more money from foreigners in the years ahead. Importantly, the increasing reliance on foreign money is a trend that has intensified since 2008. In 2008, foreign ownership of Canadian securities stood at 24.7% of GDP and has since increased to 52.6% of GDP by 2019.
Reliance on foreign money is ok in times of normalcy, but in times of stress, the reliance on foreign money can lead to dislocations, as foreigners are quick to move money back home or to safe zones - in the US, UK, and Germany. The reliance on foreign money in times of stress makes it difficult for governments, and companies to raise cash at a time when it is most needed, thereby creating systemic challenges. It goes without saying that there will be notable problems to overcome as the world navigates through the effects of COVID-19.
Structural & Temporary Growth Impediments
Over the 5 years leading up to the COVID-19 crisis, Canada recorded an average annual GDP growth of 1.7%, while the median 'AA' rated country recorded 2.9%. It is believed that the reasons for the lower than average growth are structural: burdensome environmental and energy policy, and inter-provincial trade barriers. In more recent times, the medium-term prospects for growth have dimmed further, owing to an erosion of Canada's tax advantage relative to the USA, the temporal trend of low oil prices, and even tighter environmental restrictions. Uncertainties around trade with the USA have dissipated with the implementation of the USMCA agreement, but U.S. tax law changes in 2017 has reduced the country's corporate tax advantage. Consequently, there has been and will continue to be substantial investment flows leaving the country for greener pastures. Persistent low oil prices together with regulatory bottlenecks are huge constraints on the energy industry - which happens to be the largest industry of the economy.
According to Fitch, the hit to economic activity in 2020, as a result of the spread of COVID-19 and substantially lower oil prices is expected to be -7.1% - slightly lower than IMF's estimate. The rating agency expects a slight recovery in 2021 of approximately +3.9%, before a flattening-out at around +1.7% thereafter. The issue with having such low growth is the fact that it makes it difficult for the government to raise revenues at a pace that will lead to a rapid reduction in the deficit and debt without a raise in taxes. At the same time, raising taxes is countercyclical and will likely lead to downward pressure on GDP. The result is that excessively high GDP ratios may persist for a longer time
It is Not All Bad
Canada has a number of positives that support a fairly strong credit profile. Though the country's credit rating has been reduced by 1 notch, they are still at investment grade which is still favourable in the eyes of global investors. In addition, the outlook is stable which reflects the fact that the likelihood of another downgrade in the near term is low. Canada has the following things going for it:
- A low-interest-rate environment. This low-interest-rate environment will likely continue as the central bank has pumped a lot of money into the financial system and slashed rates. Low rates also keep the debt servicing cost for the government low.
- Very large foreign asset holdings are driven by huge pension fund assets and corporate cross-border investments.
- A track record of fiscal discipline at the federal level.
- Political stability.
- An excellent macroeconomic policy framework.
- An advanced and diversified economy with relatively high income per capita.
It is still early in the COVID-19 crisis and Canada will certainly not be the only G7 nation that will see a downgrade in the credit ratings. As more data becomes available there will be others. In addition, Fitch is usually the more aggressive of the three and is usually the first to make moves. Standard and Poor's and Moody's have not yet taken any action but may do so if the economic fundamentals continue to deteriorate.