Back in March 2019, the Fitch rating agency warned that Canada’s public debt burden was incompatible with the triple-A status. Last April, our team flagged the possibility of a rating downgrade due to the COVID-19 outbreak. Without surprise, Fitch downgraded Canada’s long-term outlook from AAA to AA+ yesterday. In comparison, Canada’s rating from Fitch hit a trough of AA in 1994 before persistent surpluses led to upgrades in 2001 (to AA+) and 2004 (to AAA). Fitch’s downgrade is principally based on the deterioration in public finances this year resulting from the income support provided to individuals and companies. The bulk of the deterioration is expected to come from the federal government with a projected 16.1% deficit-to-GDP ratio in 2020, compared with a combined 3.3% only for provinces. This estimate from Fitch is similar to the International Monetary Fund (IMF) forecast published today. The IMF projects a 16.5% deficit-to-GDP ratio this year for advanced economies.
Including all levels of governments, the COVID-19 response is poised to increase Canada's public debt from 88% of GDP in 2019 to 115% of GDP in 2020, according to Fitch. The non-recurring costs related to the pandemic will contribute to shrink the size of the deficit next year, assuming a gentle second pandemic wave. This being said, the shift of some responsibilities to various levels of governments overtime may restrain the ability of Canada to get its fiscal house in order in the future:
“Canada has a track record of fiscal adjustment during the 1990s. However, the structure of Canada's decentralized fiscal framework increases the complexity of any fiscal adjustment. This increases downside risks to Fitch's expectation that general government debt will broadly stabilize beyond 2021”.
The July 8th federal update will only provide revised revenue and spending numbers for FY 2020-21. Given the uncertain recovery path, we do not expect a revamped five-year outlook or a firm commitment relative to stabilizing the debt-to-GDP ratio in the medium-term.
Besides the rapid deterioration in public finances, the second factor contributing to today’s downgrade relates to weaker external finances. Fitch notes persistent and elevated reliance of foreign portfolio flows to finance the large current account, tax competitiveness challenges relative to the U.S. and an unfavorable environment for the energy sector. Finally, Fitch forecasts Canadian real GDP growth at -7.1% this year and a moderate 3.9% rebound next year. In another report released today, the IMF sees a slightly deeper recession this year (-8.4%) followed by a 4.9% expansion in 2021. Our team will revise its Canadian economic forecasts in the coming weeks but our numbers are unlikely to be materially different.
Bottom Line: The pandemic shrinks the exclusive AAA club. As the Bank of Canada highlighted in the May Financial System Review, federal programs to cover income and cash shortfalls have mitigated financial stress and contained the severity of the recession so far. Thus, going down one notch on the rating scale is the lesser of the two evils for Canada, particularly since the BoC is able to keep interest rates low with the continuous purchase of several securities, including federal and provincial bonds.