DBRS Confirms the European Union at AAA, 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, which is underpinned by the creditworthiness of the EU’s core member states and their collective commitment to support the EU’s obligations. The ratings also benefit from the EU’s conservative budgetary management with multiple arrangements that protect creditors as well as the institution’s de facto preferred creditor status.

The Stable trend reflects DBRS’s view that the EU is positioned to manage near-term risks.

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 (AAA, Stable trend), the Republic of France (AAA, Stable 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 51% of the total budget contributions, 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.

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 supports 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 expenditure general framework for a seven-year period and establishes ceilings for the commitment and payment appropriations 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 a 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 around EUR 54 billion as of April 2016 from EUR 13 billion in 2010. The debt-to-revenue ratio increased to about 38% compared to 10% over the same period. This rise is mostly attributable to the European Financial Stabilisation Mechanism (EFSM), under which loans to Ireland (A (high), Stable trend) and Portugal (BBB (low), Stable trend) of EUR 46.8 billion account for 86.7% of total loans outstanding. Notwithstanding the relatively high loan concentration, financial assistance programmes are subject to strict policy conditionality, which mitigates credit risks. Over the medium term, DBRS projects EU debt to decline, as the ESM has assumed primary responsibility for support programs for Eurozone member states. However, 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.

The EU also faces several challenges that could have an impact on the credit quality of its core member states or on the degree of support from members. A vote by the UK to leave the EU could have negative economic and financial implications for Europe. It could also spur further support for anti-European parties across Europe. Tensions over refugee burdens, migration, and border security could also prove divisive and weaken the commitment of individual members to support the EU. Relations with Turkey and Russia present an additional challenge to forging common policies within the union. Finally, the ongoing debate over fiscal austerity and bearing the cost of Greek debt relief could weaken political support for the EU.
The 2016 budget amounts to EUR 143.9 billion in payment appropriations to support the recovery of the European economy, including more than EUR 4 billion to address the refugee crisis. The budget also includes the contribution in terms of guarantees to the European Fund for Strategic Investment (EFSI), which is at the core of the EU’s investment plan, fully operative since October 2015 aimed at triggering total investments up to EUR 315 billion. The plan is not intended to add financing commitments for the EU, as the EFSI is to be financed with EUR 16 billion guarantees from the EU budget in the coming years according the existing ceilings of the 2014-2020 MFF.

RATING DRIVERS
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. A vote by the United Kingdom to leave the EU is unlikely to have an immediate impact on the EU’s ratings, but would leave the EU increasingly reliant on the ratings of a smaller group of AAA-rated core member states. To the extent that disputes over EU policies weaken the commitment of the remaining core member states to support the EU or result in less conservative budget management, this could have adverse implications for EU ratings.

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

The principal applicable methodology is Rating Supranational Institutions, which 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 European Commission, Ameco, Eurostat, IMF WEO April 2016, Bloomberg, Haver Analytics, DBRS. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

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

This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party.

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.

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

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: Carlo Capuano, Assistant Vice President
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and
Sovereign Ratings
Initial Rating Date: 11 July 2014
Last Rating Date: 18 December 2015

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