TORONTO (Reuters) - Moody's Investors Service is "very comfortable" with its top Aaa credit rating for Canada because the country's fiscal and banking strength give it room to react to risks arising from the European debt crisis and Canada's hot housing market, Moody's chief analyst for Canada said on Thursday.
Steven Hess said he did not believe the risk from Canada's booming real estate sector was very great, but that he would not be surprised if there was some price correction. External risks from Europe would mainly flow to Canada from the United States, Canada's largest trading partner, he said.
"We still have a stable outlook on Canada and don't see any reason why that would change anytime soon," Hess said in an interview with Reuters.
"The fiscal situation being pretty good relative to other countries and ... our bank financial strength ratings for the Canadian banking system as a whole are the highest really of any banking system in the world."
Hess said if one is looking for risks to Canada they would come from high household debt and the heated housing market, but that Canada's strong banks and economic strengths would likely limit the fallout of a housing correction.
The Bank of Canada, in its semi-annual Financial System Review on Thursday, said the country's financial system remains highly vulnerable to a further escalation in the European debt crisis and the possibility of a correction in the housing market.
But even if a severe housing correction resulted in problem loans, Hess said Canada's big banks would be able to manage without having to resort to government help.
"It wouldn't be surprising if there was some correction in the housing market," Hess said. "Now will that cause a financial problem, system-wide? In the end we don't think that that risk is very great because of the lending standards that are in the banks, because the economy is still doing relatively well and employment is all right.
"You don't have the same thing that you had in the United States of people losing jobs before losing their houses. And also the legal framework surrounding foreclosures and whatever is different in Canada, and is more conducive to people continuing to service their loans."
Canada's federal housing agency said in a report on Thursday that the country's hot housing market will likely cool toward the end of 2012.
Canada and Germany are alone among G7 countries in having Moody's highest credit rating with a stable outlook. Canada's prudent fiscal management and sound banking sector have been credited with helping it survive the global recession better than many countries.
Hess said Canada's strength - including the relatively positive budget positions of the federal and provincial governments and the prospect of eventual official interest rate increases - is turning Canada into a safe haven for foreign investment.
"In some sense, the Canadian government bond and Canadian dollar assets in general are taking on some characteristics of a haven currency internationally (with) investors who are wanting to diversify away from Europe because of the situation there," Hess said.
"And with the debt-limit question coming back to the fore in the United States, maybe some diversification away from the U.S. dollar is also desirable and Canada looks like a place you could put your money."
The emergence of Canada as an alternative safe haven for foreign investment is benefiting the government in terms of low bond yields. Hess said the proportion of Canadian government debt held by nonresidents has risen in the last couple of years to about 20 percent.
That is low compared with the United States, where nonresidents hold about 50 percent of U.S. Treasury bonds, and compared with France and Germany, where it is more than 60 percent.
"In Canada it is still relatively low so there is a lot of room, if you want to put it that way, for foreign investment coming into not just the federal government but the provinces as well," Hess said. "And this means that their borrowing costs are lower than they would be otherwise. Even if the Bank of Canada raises the short-term rates, the longer-term bond market is going to benefit from foreign demand."
Last month, the federal government announced a smaller-than-expected budget deficit for 2011-12, giving Finance Minister Jim Flaherty some leeway to react if needed to what he called an "unstable" situation in Europe, and keeping Ottawa on track in its plan to balance the budget by 2015-16.
Hess said Canada can't escape feeling the effect of any return to fiscal crisis in the United States or a knock-on effect of the euro zone debt crisis or breakup.
"It's not something we are predicting, but the risk to the financial system coming from Europe, for example, is there. And that would obviously have some spillover effects on Canada because of the close association of Canada and the U.S.," Hess said.
(Reporting By Andrea Hopkins and Claire Sibonney; Editing by Peter Galloway)