DBRS Confirms AAA Rating on the European Union, Stable trend

DBRS Ratings Limited (DBRS) has 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 at AAA primarily on the basis of its Support Assessment, in which the credit ratings of the EU’s core member states are 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’s 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’s core member states could put downward pressure on the EU’s ratings, particularly if the credit deterioration is caused by flagging cohesion of the EU or a weakening of the political commitment of EU’s core member states and borrowers. In addition, ratings could be pressured if the withdrawal of a EU member state leads to a weakening of the commitment of the member states to the EU and results in less conservative budget management.

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 supporting the EU’s 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: the Federal Republic of Germany (Foreign Currency rating of AAA, Stable trend), the Republic of France (AAA, Negative trend), the United Kingdom (AAA, Stable trend) and the Republic of Italy (A (low), Stable trend). Because Germany, France and the United Kingdom account for 50.2% 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 and 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’s ratings. However, the EU’s ratings could be lowered if several core member states experience rating 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 the EU’s gross national income (GNI) over the 2014 to 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 needed 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's credit challenges arise mainly from its highly concentrated lending portfolio. Loans outstanding have increased significantly since 2011, reaching EUR55.51 billion in December 2015 from EUR13 billion in 2010, with the debt-to-revenue ratio increasing to 39% from 10%. This rise is mostly attributable to the European Financial Stabilisation Mechanism (EFSM), under which loans to Ireland (A, Positive trend) and Portugal (BBB low, Stable trend) of EUR46.8 billion account for 84% 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, as the EFSM is no longer engaged in new lending programmes. Nevertheless, DBRS expects the EU to remain active in capital markets until at least 2026 because of the lengthening of loan maturities following the increase in the maximum average maturities of EFSM loans to Ireland and Portugal.

Concerns over the United Kingdom leaving the EU and the ongoing refugee crisis have complicated the policy agenda at the EU level. The United Kingdom’s government decision to hold a referendum on EU membership by the end of 2017 is likely to increase political uncertainty over the medium term. DBRS, however, does not expect the EU’s overall credit risk profile to change materially in the event of a British withdrawal, given the EU’s robust institutional and budgetary framework. A British exit from the EU would likely be followed by a lengthy transition period, during which many legal issues and trade and budgetary arrangements would need to be agreed upon. DBRS would expect the transition to be managed carefully to avoid financial disruptions.

Challenges for a sustainable solution to the large influx of refugees are likely to persist, testing the cohesion between EU member states. The number of first time asylum applicants amounted to 413,000 in the third quarter of 2015, more than 150% compared with the same quarter of 2014. To alleviate the problems, a proposal by the European Commission to relocate 120,000 applicants via a mandatory mechanism was voted by a majority in the European Council in September, although it was strongly opposed by four Central European member states. This is the first time that a sensitive issue has not been resolved by a consensus decision, potentially introducing uncertainty over the decision-making process in other policy areas in the future.

The 2016 budget, approved in November, amounts to EUR 143.9 billion in payment credits to support the recovery of the European economy including increased resources (EUR 4 billion) to address the refugee crisis and conflicts in Syria and Ukraine. The budget also includes contributions to the European Fund for Strategic Investment (EFSI), which is at the core of the EU’s investment plan announced in November 2014 aimed at boosting investments in 2015 to 2017 by EUR 315 billion. The plan is not expected to add financing commitments for the EU, as the EFSI is to be financed within the existing ceilings of the 2014-2020 MFF. A total of EUR 21 billion will be mobilised. These include an EU guarantee worth EUR 16 billion, which is backed by the EU budget, and EUR 5.0 billion to be provided by the EIB. From the EU budget, EUR 8.0 billion is already re-appropriated to cover up to 50% of the guarantee, while the remaining EUR 8.0 billion of guarantees is expected to be subsequently built up in the upcoming budgetary years. The EFSI became operational in October 2015 and projects have already started receiving financing from the EIB. Although the EFSI investments will occur progressively, DBRS believes this will initially lead to an increase in the contingent liabilities of the EU over the near term as the EFSI supports projects with a relatively high-risk profile.

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.

These can be found on www.dbrs.com at:
http://www.dbrs.com/about/methodologies

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.

DBRS does not typically accept editorial changes other than to correct for factual, accuracy and/or to remove confidential, material non-public, or sensitive information that might otherwise be inadvertently disclosed.

Lead Analyst: Giacomo Barisone
Initial Rating Date: 11 July 2014
Rating Committee Chair: Roger Lister
Last Rating Date: 3 July 2015

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