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Canada remains at the top of the world's credit-rating heap thanks to its fast-approaching balanced budget and a stable banking system, but the country's high household debts and climbing house prices pose "a potential risk" to those strengths, Moody's Investors Service said.

Moody's, one of the world's leading credit-rating agencies, said in its annual report on Canada that the federal government's AAA rating and "stable" outlook are supported by its improving finances, Canada's "relatively solid economic performance," and its strong institutional and regulatory framework.

However, it warned, the housing market and consumer debt could threaten these healthy conditions.

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"This combination presents a potential risk to the banks and to the federal government directly, as it guarantees a considerable portion of mortgages," said Moody's senior vice-president Steven Hess, the report's author.

"We believe that this increased vulnerability presents the largest downside risk to our medium-term forecast," he wrote in the report.

The report said Canada's housing market "appears to be particularly inflated, especially in the largest metropolitan areas." It said that while a slowdown in home construction has already begun, a further downturn is possible, "leading us to conclude that Canada's real estate market continues to pose downside risks to our [economic] growth forecast."

Mr. Hess argued that there are "no signs of a soft landing for the housing market in sight" – a view that is at odds with that of the Bank of Canada.

It added that as Canada's interest rates rise to more normal levels in the coming years from their current historic lows, both house prices and consumers' near-record debt loads will come under pressure.

"Absent a meaningful pickup in employment and real income levels, declining or even stabilizing housing prices and tighter credit may translate into lower consumer confidence, potentially resulting in weakening consumer demand and, by extension, slower GDP growth," the report said.

"Alternatively, the housing market may correct in response to a macroeconomic shock, a scenario that is more likely to lead to significant weakness in consumer demand than the scenario of a [interest rate] policy-induced correction. With real estate accounting for an increasingly higher share of household wealth, stress in the housing market has the potential to exacerbate exogenous shocks."

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Moody's concern about Canada's housing market and consumer debt has risen considerably from last year's annual report. At that time, it said it believed that Ottawa's tightening of mortgage regulations had cooled the housing market and that household debt levels had stabilized.

This year's report also warned that Canada's sluggish business capital investment – an issue that has been a major concern for the Bank of Canada – poses a threat to Canada's longer-term economic prospects.

"Persistently weak investment in manufacturing equipment and intellectual property may erode the diversity and competitiveness of Canada's economy and increase its dependence on mining and oil and gas, a development that may put its economic strength at risk in the long run."

But despite these risks, Mr. Hess wrote, "we do not view recent economic developments as structural shifts, and believe that Canada's long-term growth prospects have not deteriorated."

And the rating agency lauded the federal government's deficit-reduction progress, as the budget is expected to go into surplus in fiscal 2015-2016. It said Canada's federal debt-to-GDP ratio, a key measure of credit health, has already declined to 32.5 per cent from its peak in 2012 of 33.5 per cent, and should continue downward in the coming years, toward the government's target of 25 per cent by 2021.

"At the federal level, this debt compares favourably to other highly rated federal states," Moody's said. "The debt of the provinces is large, but in general their credit profiles are very strong." It added that it believes all federal parties are committed to balanced budgets and debt reduction over the long term.

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Speaking in Beijing Monday, federal Finance Minister Joe Oliver indicated that Ottawa remains committed to delivering income-tax cuts once the budget moves into surplus, although the government is still weighing its options on what form that will take.

"What I've said is that we will provide a tax relief for hard-working Canadians. What I haven't defined is what the nature, the specific nature of that relief will be, and people will have to wait for that announcement. But we are comfortable that we are going to achieve a surplus next year, and that will give us the flexibility to provide tax relief without going back into a deficit," Mr. Oliver said at an event at the Canadian embassy.

"I can't comment on what will or will not be in the budget. I know there's a great deal of curiosity about this subject, my colleagues and I will be consulting broadly with Canadians right across the country," he said.

With files from Nathan VanderKlippe in Beijing

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