DBRS Confirms AAA Ratings to the European Union, Stable Trend

DBRS Ratings Limited (DBRS) has today confirmed the long-term issuer rating of the European Union (EU) at AAA and the short-term issuer-rating at R-1 (high). The trend on both ratings is Stable.

DBRS rates the EU AAA primarily on the basis of its Support Assessment, in which the credit ratings of the EU’s core member states is the primary factor. The ratings are underpinned by the creditworthiness of the EU’s core member states and their collective commitment to support the EU's ability to repay its debt. The ratings also benefit from the EU’s conservative budgetary management with multiple arrangements that protect creditors and the institution’s de facto preferred creditor status.

The Stable trend reflects DBRS view that the near-term risks to the EU’s ratings are low. However, the ratings could be lowered if there is deterioration in the support assessment, or if the EU were to experience a material deterioration in its risk profile. Multiple notch downgrades of EU core member states could put downward pressure on the EU’s ratings, particularly if the credit deterioration is the result of deterioration in the cohesion of the EU, or a weakening of the political commitment of core EU member states and borrowers. In addition, a weakening of the commitment of the member states to the EU and changes to the EU's fiscal framework that lead to less conservative budget management would put pressure on the ratings.

The Support Assessment is based on the overall credit quality of the EU’s core member states and their collective commitments to support the EU. DBRS believes that EU member states have consistently shown strong commitment to support its key functions, as demonstrated through the activation of a number of financial support mechanisms used in response to the financial crisis, as well as through funds that member states continue to contribute to the EU budget. Moreover, as established by the founding Treaties, EU member states share joint responsibility to provide the financial resources required to service the EU's debt. In this context, the EU's rating is particularly sensitive to changes in the ratings of the four countries with the largest contributions to the EU budget, i.e., the Federal Republic of Germany (which currently has a foreign currency rating of AAA Stable), the Republic of France (AAA Negative), the United Kingdom (AAA Stable) and the Republic of Italy (A low Negative). Because Germany, France and the UK account for 50% of the budget revenues, the weighted median rating of the core members is AAA.

Given the strong political commitment of the member states to the EU, the added benefits associated with member states’ diversification, as well as the EU’s multiple sources of support, the EU’s ratings are not sensitive to a one-notch downgrade of core member states’ ratings. In other words, a one-notch downgrade of any single core member state is unlikely to result in a downgrade of the EU ratings. However, the EU ratings could be lowered if several core member states experience ratings downgrades, or if there is a marked deterioration in the creditworthiness of a single AAA-rated core member state.

Although the EU does not benefit from any paid-in capital, its debt servicing capacity is backed by multiple arrangements that protect creditors. First, all EU borrowings are covered by the EU’s available resources with annual revenues averaging up to 0.99% of EU Gross National Income (GNI) over the 2014-2020 period. These funds can be prioritized for debt service, whether or not they have been committed elsewhere. Secondly, if these amounts are not sufficient, member states are legally obliged to provide the funds necessary to repay the debt and balance the budget, up to a ceiling of 1.23% of EU GNI. If necessary, EU legislation allows member states to contribute more than their share to the EU budget.

The EU’s conservative budgetary management further underpins the ratings. The EU is not permitted to borrow funds for purposes other than to finance its lending programme. In addition, the Multiannual Financial Framework (MFF) provides the general framework for a seven-year period and establishes a ceiling for total expenditures for the annual budgets during that period. Lending and borrowing activities follow strict prudential rules with back-to-back funding typically matched to loans in terms of maturity, interest payments and currency. As a result, the EU budget does not incur any interest rate or foreign exchange risks. In addition, DBRS recognizes that, as for several other supranational institutions, the EU has preferred creditor status: if debtors face payment difficulties, debt repayment to the EU will likely take priority over funds owed to other creditors.

The EU issues debt to provide loans to sovereigns facing financial difficulties under three programmes: the European Financial Stabilisation Mechanism (EFSM) loans available to all EU member states; Balance of Payment (BoP) loans dedicated to EU member states outside the euro area facing external difficulties; and Macro-Financial Assistance (MFA) loans available for non-EU member states. In addition, the Commission issues bonds on behalf of the European Atomic Energy Community (EURATOM) which are also backed by the EU budget, and the EU also assumes the sovereign risk of loans granted by the European Investment Bank (EIB) to countries outside the EU, which is backed by an internal guarantee fund and the EU budget. The guarantee fund is also used to back the EURATOM and the MFA loan exposure.
Loans outstanding have increased significantly since 2011, reaching EUR57 billion in December 2014, from EUR13 billion in 2010, with the EU's debt-to-revenue ratio increasing to 41% from 10%, respectively. This rise is mostly attributable to the EFSM programme, under which loans to Ireland (A low, Positive) and Portugal (BBB low, Stable) of EUR46.8 billion account for 76% of total loans outstanding. Notwithstanding the relatively high loan concentration in weaker euro area sovereigns, financial assistance programmes are subject to strict policy conditionality, which mitigates credit risks. Over the medium term, DBRS expects EU debt to decline, with the EFSM no longer engaged in new lending programs. Nevertheless, DBRS expects the EU to remain active in capital markets until at least 2026, due to the potential lengthening of loan maturities following the increase in the maximum average maturities of EFSM loans to Ireland and Portugal.
The EU's planned investment plan, announced in November 2014 and aimed at boosting investments by EUR315 billion in 2015-2017, is not expected to add additional financing commitments for the EU. The plan centers around the creation of a new fund called the European Fund for Strategic Investments (EFSI) to be financed with a total of EUR21 billion of existing funds. These include an EU guarantee worth EUR16 billion which is backed by the EU budget, and EUR5 billion to be provided by the EIB. From the EU budget, items of EUR8 billion are already re-appropriated to cover up to 50% of the guarantee, while the remaining EUR8 billion of guarantees are expected to be subsequently built up in the upcoming budgetary years.

Notes:
All figures are in euros (EUR) unless otherwise noted.

The principal applicable methodology is Rating Supranational Institutions, which can be found on the DBRS website under Methodologies. Other applicable methodologies include the following: Ratings Sovereign Governments. These can be found on the DBRS website under Methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales.

The sources of information used for this rating include the European Commission, Bloomberg and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Information regarding DBRS ratings, including definitions, policies and methodologies are available on www.dbrs.com.

This is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period, while reviews are generally resolved within 90 days. DBRS’s outlooks and ratings are under regular surveillance.

For additional information on this rating, please refer to the linking document under Related Research.

For further information on DBRS historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings Limited are subject to EU regulations only.

Lead Analyst: Giacomo Barisone
Initial Rating Date: 11 July 2014
Rating Committee Chair: Roger Lister
Last Rating Date: 11 July 2014

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