Canada’s Aaa sovereign rating and stable outlook could probably withstand even the worst-case Nafta scenario in which no agreement is reached and the country faces new tariffs, according to Moody’s Investors Service.

While the base case for Moody’s is for Canada to ultimately sign a new North American Free Trade Agreement with the U.S. and Mexico, the rating company is confident the northern nation would be able to adapt if no deal is signed and the U.S. slaps it with auto tariffs.

“We would expect the economy would adjust in some way to that shock from the worst-case Nafta scenario, probably by shifting some of their exports to other markets and maybe changing the production function in some capacity,” William Foster, vice president at New York-based Moody’s said in a telephone interview. “It would certainly weigh on growth, as initially it would weigh on investment and confidence, but that would be temporary. We would expect this to pick up again as things become more clear.”

The U.S. is set to publish the text of a bilateral trade accord with Mexico on Friday but officials from Washington and Ottawa remain at loggerheads despite weeks of face-to-face negotiations. The impasse is raising fears the U.S. will leave Canada, its biggest export market, out of the renegotiated trade bloc, resulting in potential barriers for more than US$500 billion in annual cross-border trade.

Markets Adapt

If Canada isn’t included in a new trade deal, the countries would probably revert to World Trade Organization rules, which wouldn’t have a major impact on Canada, Foster said.

While Canada’s economic reliance on the U.S. is large, debt-to-GDP ratios and deficits are both on downward paths and are at manageable levels, Foster said. Canadian policy makers have also proved willing in the past to respond to economic shocks, including to the slump in oil prices four years ago, he said.

Although further protectionist measures would undoubtedly have a negative impact on growth and therefore revenues, debt markets would price in materially less tightening from the Bank of Canada which would probably cause yields to fall, Andrew Kelvin, senior Canada rates strategist at Toronto Dominion Bank in Toronto, said.

"Moreover, there is significant demand for longer duration Government of Canada bonds, so I would expect the market to absorb any increase in GoC issuance without too much difficulty," he said in an email.

Only 12 nations are currently rated as Aaa by Moody’s. The last time Canada lost the trust of international credit graders was in the early 1990s, when swelling government indebtedness elicited downgrades from Standard & Poor’s and Moody’s. Moody’s and S&P raised their credit ratings for the country to AAA in 2002, while Fitch Ratings upgraded it in August 2004.

--With assistance from Josh Wingrove.