Fitch Affirms Province of Ontario, Canada’s IDR at ‘AA-‘; Outlook Stable

NEW YORK

Fitch Ratings has affirmed the following ratings for the Province of Ontario, Canada (the province):

–Long-term Issuer Default Rating (IDR) at ‘AA-‘;

–Long-term local currency IDR at ‘AA-‘;

–Short-term IDR rating at ‘F1+’.

The Rating Outlook is Stable.

SECURITY

The bonds are senior unsecured obligations of the province to which the province’s full faith and credit is pledged. Commercial paper notes are promissory notes ranking equally with Ontario’s other unsubordinated and unsecured indebtedness.

KEY RATING DRIVERS

FISCAL 2016 BUDGET CONTINUES DEFICIT ELIMINATION PLAN: The enacted budget for fiscal 2016 furthers the province’s revised plan to eliminate its annual structural budget deficit by fiscal 2018. The C$8.5 billion deficit forecast is a decline from the C$10.9 billion recorded in fiscal 2015, which marked the second year of increase in the level of annual deficit. The budget incorporates the expected sale of provincial assets, including the sale of an approximate 15% of the common shares in Hydro One with the net proceeds to be directed to transit and transportation capital improvement projects, and continued expenditure restraint, which Fitch expects to remain challenging.

STRONG FINANCIAL MANAGEMENT: Through fiscal 2015, the province has continued to progress toward a multiyear financial consolidation plan to achieve fiscal balance by fiscal 2018. The province has demonstrated the ability to exert considerable, ongoing expenditure restraint while instituting revenue changes as necessary to achieve its deficit reduction objectives, pointing to the strength of provincial management.

SIGNIFICANT FINANCIAL IMBALANCE: The province had an accumulated deficit equal to 157% of operating revenues in fiscal 2015 (25.8% of gross domestic product [GDP]) due to slow revenue growth, increasing expenditures, and sizable capital borrowing that included funding for the province’s annual deficit. Annual deficits through the forecast period of fiscal 2018 will contribute to growth in the accumulated deficit.

SIZABLE, DIVERSE ECONOMY: The province’s diverse economy includes Canada’s largest business and financial hub and accounts for 39% of the country’s population. Sizable concentration remains in the large, cyclical manufacturing industry, although it has been offset in recent years by positive growth in trade, financial services, and education and health care services, diversifying the economic base. The provincial economy remains heavily linked to that of the U.S.

LARGE AND GROWING DEBT BURDEN: The province has a high debt burden (net direct debt to GDP) with net debt to GDP at 39.4% for fiscal 2015, although debt service expense is a manageable 8% of annual expenditures. Fitch expects net debt levels to increase through fiscal 2016, then begin to decline. Pensions are well funded.

RATING SENSITIVITIES

The rating is sensitive to the province’s commitment and success in achieving deficit elimination targets and restoring fiscal balance. Failure to enact budgets that follow a path toward articulated deficit elimination targets would result in negative rating pressure. Reaching deficit elimination targets ahead of forecast, sizable growth in GDP, and steady progress on lowering debt burden and the accumulated deficit would be positive credit factors.

CREDIT PROFILE

Ontario’s ‘AA-‘ rating is supported by its wealthy, diversified economy and generally sound financial management. The province is making a slow recovery from the recession that subdued its economic growth, slowed its tax revenues, and resulted in increased debt levels as it funded a multi-billion dollar economic stimulus program and participated in the joint Canada-U.S. bankruptcy settlement with Chrysler and General Motors (GM).

The province made steady, positive progress through fiscal 2014 in implementing its financial plan to return to fiscal balance in fiscal 2018 largely through expenditure restraint aided by modest revenue measures and a stabilizing economy. The fiscal 2015 budget was enacted with an expected increase in the annual deficit in deviation from the 2010 consolidation plan; to C$12.5 billion compared to C$10.5 billion in fiscal 2014. The province was able to reduce the fiscal 2015 deficit to C$10.9 billion at year-end, a much smaller increase from the deficit in fiscal 2014.

Although Fitch notes the progress that has been made to date, full fiscal recovery remains several years away and will require sustained economic and revenue growth together with continued control over provincial expenditures. Fitch believes that the province will also be challenged in restraining ongoing capital spending to make progress in lowering the high debt burden and accumulated deficit over time.

LARGE, DIVERSE ECONOMIC BASE

The province is Canada’s largest by population, and its diverse economy generates 37% of Canada’s GDP. Provincial GDP gains have been steady since the recession but trail national averages; GDP growth of 1.3% compared to Canada’s 2% in 2013. Motor vehicles and parts manufacturing, which were severely affected in the recession, notably improved in 2014 with 5.9% year over year (yoy) growth compared to a 4.1% yoy decline in 2013. The manufacturing industry as a whole has markedly declined as a contributor to provincial real GDP (12.8% of provincial GDP [chained 2007 dollars] in 2013, down from 20.3% in 2000) reflecting less robust growth in this industry as well as solid growth in trade, transportation, financial activities, and education and health services. Positively, manufacturing recorded 3.8% annual production growth in 2014.

The broader economy of Ontario, and that of the nation, has evidenced continued slow improvement since the downturn, with yoy job gains in 2015 following 0.8% growth in 2014. May 2015 saw job growth of 0.9% in Ontario, slightly below 1% for the country as a whole. May 2015 unemployment in Ontario was 6.5%; down from 7.2% recorded a year earlier, and below the national rate of 6.8%; a positive deviation from recent history.

MIXED PROGRESS ON FINANCIAL PLAN IMPLEMENTATION

Ontario’s fiscal 2010 ended with a C$19.3 billion operating deficit (20% of revenues) and an accumulated financial deficit of almost C$131 billion (136% of revenues). The province subsequently enacted its multiyear budget-balance plan in fiscal 2011 with the goal of improving its operating margins and reaching a balanced budget by fiscal 2018. Through fiscal 2014, Fitch notes that the province exceeded the targets as expressed in the plan while facing the challenge of slower GDP growth than originally forecast, requiring additional revenue and expenditure measures to achieve its annual goals. At the close of fiscal 2014, the annual operating deficit was C$10.5 billion and the accumulated deficit reached C$176.6 billion.

For fiscal 2015, the province budgeted for an increase in the annual deficit; to C$12.5 billion, diverging from both the 2010 fiscal consolidation plan and trends up until that time. The province forecast 2.8% revenue growth in support of the enacted budget that grew expenditures by 2.7%. The province’s revenue forecast was lowered in the Fall of 2014 (by C$509 million) largely due to lower tax revenue than anticipated. The negative revision was expected to be offset by expenditures that were running below budget and application of C$300 million of reserve funds. Interim revenue, while 0.3% lower than the budget forecast, was ahead of the Fall 2014 expectation while total expenditures came in 0.7% below budget. The ending operating deficit of C$10.9 billion, while still C$480 million above fiscal 2014, was an improvement from earlier expectations.

The enacted budget for fiscal 2016 continues the province’s expenditure control supported by expected solid growth in revenue sources. To the extent that revenues do not perform as forecast, the province will be required to implement expenditure reductions on already streamlined operations to achieve its target of a C$8.5 billion deficit at year-end. Other measures in the budget include a continued ‘optimization of provincial assets’ whereby assets are sold and proceeds delivered for other provincial priorities, largely the province’s transit and transportation capital improvement projects. Based on results on the consolidation plan to date, Fitch believes the province will achieve its deficit target in fiscal 2016.

The province continues to actively manage its revenue assumptions in the context of changes in its economic forecast. The economic and revenue forecast, released in April 2015 in conjunction with the fiscal 2016 budget, forecasts GDP growth in 2015 of 2.7% and 2.4% for 2016; forecasts that Fitch believes are reasonable based on results to date. The GDP forecast, combined with its expectation for salary, wage, and employment growth, leads to the province’s expectation of 3.8% growth in baseline taxation revenues. This assumption incorporates 5.2% baseline growth in the PIT and 4.7% growth in sales tax revenue; this reflects expected 4% growth in employee compensation, a robust forecast in Fitch’s view. Overall, revenues are forecast to grow 5% from fiscal 2015, but this measure is from a base in fiscal 2015 that was lower due to prior period adjustments recorded in that fiscal year and is inclusive of the sale of approximately 15% of the common shares of Hydro One, the province’s electric utility. Expenditures are budgeted to increase by 1.9% and include modest increases in most areas of government offset by an expectation of C$1.5 billion in programmatic savings.

CHALLENGES TO PLAN EXECUTION; DEBT BURDEN WILL CONTINUE TO INCREASE

Despite the setback in fiscal 2015, the province continues to target fiscal 2018 as the year in which it will recover budget balance. The remaining years of the balancing plan continue to require the exercise of expenditure restraint and the province has demonstrated a willingness to look at revenue options should economic conditions preclude required baseline revenue increases.

Fitch believes expenditure targets will continue to be challenging but achievable. The province’s current plans are for steady reductions in the annual deficit in fiscal years 2016 and 2017, but both years’ projected deficits are above the 2010 targets.

Even if the province achieves its budget balance goal by fiscal 2018, it will be left with a sizable accumulated deficit and large debt burden that will have grown from earlier levels. The provincial goal is to bring the debt burden back down to 27% of GDP; given the current level of almost 40%, Fitch believes that this is likely to prove challenging. A further substantial hurdle will be reducing the accumulated deficit which is currently forecast to increase to C$195 billion, equal to 26% of projected nominal GDP, in fiscal 2016.

SUBSTANTIAL BUT MANAGEABLE DEBT BURDEN

The province’s debt burden has expanded greatly from financing its fiscal imbalances since the recession. Gross debt to GDP, including debt of consolidated entities and pension liabilities, was 42.5% in fiscal 2014, and is estimated to have grown under the current plan to approximately 43.6% in fiscal 2015. Net debt to GDP of 39.4% in fiscal 2015 is forecast to peak at 39.8% in fiscal 2016 before trending steadily downward. As noted above, the province has set an ambitious goal of bringing the debt burden to a more manageable 27% of GDP after fiscal 2018. Total borrowing in fiscal 2016 is forecast at approximately C$31 billion, of which C$9.1 billion is for capital purposes and the remainder largely for repaying debt maturities and funding the annual deficit. Interest on outstanding debt remains manageable, at 9% of expenditures in fiscal 2015 and pensions are well funded.

Additional information is available at ‘www.fitchratings.com‘.

Applicable Criteria

International Local and Regional Governments Rating Criteria (pub. 18 May 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=865254

Tax-Supported Rating Criteria (pub. 14 Aug 2012)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686015

Additional Disclosures

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Solicitation Status
https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=987559

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

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Fitch Ratings
Primary Analyst:
Marcy Block, +1-212-908-0239
Senior Director
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst:
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Senior Director
or
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Managing Director
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Media Relations, New York
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