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Canada’s AAA on the Line as Oil Crash Hits Debt-Loaded Provinces

By Esteban Duarte

(Bloomberg) Canada’s stellar credit rating is being put to the test as the oil crash and recession expose the country’s weak link: its provinces.Among the Group of Seven countries, only Germany and Canada have AAA ratings from S&P Global Ratings. But as pressure rises on the government of Justin Trudeau to aid provinces and key industries, Canada’s fiscal position is looking shakier.

Going into the Covid-19 crisis, Canada’s provincial governments had C$853 billion ($602 billion) of debt securities outstanding, more than the national government. They also shoulder most of the cost for health care and eduction. Several of them rely on energy revenues that are evaporating. Oil-rich Alberta released a budget in February based on West Texas Intermediate prices of $58 a barrel. Its deficit projections crumbled within days.

Last week the Bank of Canada expanded its asset purchase program to include as much as C$50 billion in provincial debt to bring down yields. That may not be enough: Trudeau will likely have to come up with new fiscal measures too.

“There is a very good chance that the need for more massive federal assistance for the provinces, for households, for the business sector, will trigger a downgrade at some point” for Canada, said David Rosenberg, founder of Rosenberg Research and Associates and former chief North American economist at Merrill Lynch & Co.

A ‘Weak’ AAA

Canadian governments will have net borrowing needs of 11.8% of GDP this year, higher than all G7 countries except the U.S., according to the International Monetary Fund.

Pricing on credit default swaps suggests traders see Canada’s profile as similar to Australia — whose top credit rating was put on negative outlook by S&P on April 7 — and lower-rated New Zealand. Canada’s economy is set to contract by 5.3% in 2020, compared with 2.4% decline globally, S&P said in an April 20 note.

The federal and provincial governments have put together a virus response package of at least C$315 billion, S&P said.

“The fact that the Bank of Canada is now buying provincial debt, and that will help keep borrowing costs low — I think that will be very important for the credit rating,” said Tiffany Wilding, North American economist at Pacific Investment Management Co. She sees the Canada’s top credit rating as “extremely resilient,” citing the central government’s relatively low debt-to-GDP ratio, which was a little more than 30% before the crisis.

Fitch Ratings, which is in the process of updating its projections for Canada as well as other sovereigns, looks at gross consolidated general government debt rather than federal debt in its models, said Kelli Bissett-Tom, a director of Americas sovereign ratings. By that yardstick Canada is “among the weak” AAA-rated sovereigns, she said, though it isn’t an automatic trigger for a credit action.

Implicit Support

While the federal government doesn’t explicitly guarantee the debt issued by provinces, credit-rating companies and investors assume a high probability of support.

For instance, Newfoundland and Labrador’s rating of A1 by Moody’s Investors Service would be two levels lower if not for the assumption of “a high level of extraordinary support from the government of Canada,” Moody’s said in an April 1 statement. Moody’s put the province on negative outlook, citing the decline of oil prices. It’s the most indebted province, with debt at about 2.5 times revenues for the fiscal year that ended March 31.

Newfoundland and some other provinces, including Manitoba, want the Trudeau government to set up an emergency credit agency to help them borrow more cheaply. They also want changes to the fiscal stabilization program, a federal mechanism created in the 1960s to help provinces facing revenue drops.

Borrowing costs for provinces declined after BoC started debt purchase plans

“We still believe the proposal for an emergency fund has merit, and we will continue to work with our provincial counterparts and the federal government on solutions to the challenges we collectively face,” said Newfoundland Finance Minister Tom Osborne.

Alberta continues to press for a package of between C$20 billion and C$30 billion to help oil and gas companies stay afloat, Alberta Finance Minister Travis Toews said.

“Oil and gas is the largest subsector of the Canadian economy and we have advocated to the federal government that the liquidity package needs to be significant,” said Toews in an emailed statement.

Provincial debt issuance for this year may reach C$150 billion compared with about C$100 billion estimated before the Covid-19 outbreak, Bank of Nova Scotia analysts including Rebekah Young wrote in an April 15 note. That’s on top of federal financing needs of about C$450 billion.

“Provincials are absolutely key for Canada’s rating, because provincial debt in Canada collectively makes up the largest sub-sovereign debt issuance in the world,” said Alexandra Gorewicz, portfolio manager at CI Investments. Some of the provinces’ credit ratings may be “called into question.”

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