Dominion Bond Rating Service has released a report on the finances of the Canadian federal and provincial governments noting improving credit trends, although spiraling health care costs should keep governments under pressure.

DBRS’s 2005 federal and provincial rating reviews indicated a generally improving trend in credit profiles, as evidenced by a number of positive rating actions. Debt growth remains manageable, while fiscal balances are sound, it says.

However, health care and capital needs will keep fiscal results under pressure over the medium term, with health expenditures driven by rising demand and costs, while capital spending is driven by growth needs and aging infrastructure, it notes.

Nevertheless, DBRS expects ratings to remain sound over the next few years, noting that the federal and provincial governments in Canada posted better-than-anticipated aggregate results in 2004-05, supported by sound economic and revenue growth.

“The federal government had a sizeable budget surplus coming into the end of the fiscal year, which was whittled down to a smaller-than-budgeted $400 million by increasing transfers to the provinces at year end,” says DBRS analyst and study author Ryan McGaw. “Nonetheless, the federal net debt-to-GDP ratio remained on its downward trend.”

Driven by higher federal transfers, as well as solid own-source revenue growth in many provinces, the aggregate provincial balance was in a surplus position of $678 million, compared to original projections of a $10.6 billion deficit. McGaw noted that “Improvement was especially notable in Alberta, due to strong oil prices, and Ontario, due to federal transfers and strong corporate tax revenues.”

Fiscal balances are projected to weaken in 2005-06, with the aggregate provincial balance set to slip to a $5.2 billion DBRS-adjusted deficit according to budget projections, or 0.4% of GDP. The reversal of fortunes is largely due to the decrease in federal transfers after the significant one-time injections in the prior year, and increased spending in the key areas of health care, infrastructure, and education, the rating agency explains.

DBRS projects that the worsening budget balances will boost debt growth to 3.3% in 2005-06 from 1.2% in the prior year, with most provinces increasing their debt burdens. Nova Scotia is a notable exception as it received an upfront cash payment of $830 million from the Atlantic Accord, which was entirely allocated to debt, supporting an estimated 5.8% decrease in DBRS-adjusted debt.

“Federal and provincial credit profiles remain relatively sound,” adds McGaw. “However, health care and infrastructure needs will keep fiscal results under pressure. Health care costs remain the largest and fastest rising spending item in all provinces. An aging population, rising labour costs, and increased use of costly drugs and technology will drive spending.”

Although federal funding has increased and provinces continue to seek ways to control costs, more drastic reforms will be needed to keep health care costs manageable, DBRS suggests. However, the sound economic outlook for the provinces should support revenue growth over the medium term, providing some offset to spending pressures.