DBRS Confirms Grand Duchy of Luxembourg at AAA, Stable Trend

DBRS Ratings Limited (DBRS) has confirmed the Grand Duchy of Luxembourg’s long-term foreign and local currency issuer ratings at AAA and its short-term foreign and local currency issuer ratings at R-1 (high). The trend on all ratings remains Stable.

The rating reflects Luxembourg’s sound public finances, its solid institutions and political environment, its wealthy and advanced economy, and its strong external position. These credit strengths counterbalance the challenges associated with the country’s relatively limited degree of economic diversification, its vulnerability to external shocks, and potential changes in tax frameworks that could adversely impact the tax revenue base.

The Stable trend reflects the strong fundamentals of Luxembourg’s economy and DBRS’s assessment that the challenges Luxembourg faces are manageable. Despite risks of financial market volatility, the economy is expected to continue to grow at a strong pace. Although the tax reform is set to reduce the fiscal space, Luxembourg’s public finances are expected to remain sound, with fiscal balances and low government debt supported by a robust fiscal framework.

The ratings for Luxembourg are supported by its sound public finances. The general government surplus has averaged 1.3% of GDP over the past ten years, and is estimated at 1.6% in 2016. The tax reform, in effect from the beginning of 2017 and aimed at easing the tax burden on households and firms, is set to affect the fiscal position. Nevertheless, a balanced budget is still expected to be maintained and the structural balance is projected to remain positive. Luxembourg also exhibits one of the lowest government debt levels in Europe. The gross debt ratio is estimated at 21.0% of GDP in 2016, well below both the Maastricht reference ratio of 60% and the government’s medium-term ceiling of 30%.

Luxembourg’s degree of political stability is high and its institutional quality is strong. The country ranks highly in the World Bank governance indicators, above the average of OECD countries. This position reflects a low degree of corruption, a strong rule of law, a high level of transparency and institutional capacity, and a solid regulatory environment. Luxembourg has a credible fiscal framework and robust financial supervision.

The Grand Duchy’s wealthy and advanced economy is another major credit strength. Although economic output can be volatile, reflecting the small size and high degree of openness of the economy as well as the presence of a large international financial sector, Luxembourg’s high incomes and sound household balance sheets provide the country with an important buffer against shocks. Income per capita, estimated at USD 101,936 in purchasing power parity in 2016, is 2.3 times higher than the Euro area (EA) average. After estimated real GDP growth of 3.8% in 2016, growth is forecast at close to 4.0% in 2017 and 2018.

Luxembourg’s external position is also strong, reflecting current account surpluses and a large net external asset position. The current account surplus is large at an average of 5.6% of GDP over the past five years, supported by sizable exports of financial services. The country is also a net external creditor, with a net international investment position of 39% of GDP on average between 2011 and 2015. The UK’s departure from the European Union (EU) could affect services exports, but it could equally have a positive impact on Luxembourg, if financial companies decide to partially relocate from the UK to Luxembourg.

Despite these strengths, Luxembourg faces some credit challenges. First, the degree of economic diversification is limited, as the financial sector is the leading sector of the economy. The sector accounts for 27% of gross value added, 50% of exports and 18% of budget revenues. The role the sector plays in Luxembourg exposes the country to structural changes in financial markets. Nevertheless, policy efforts to diversify the economy away from the financial sector to other high-value added industries are ongoing.

Second, the large international financial sector makes Luxembourg vulnerable to external shocks. Turmoil in financial markets and revaluation of global financial risks could have an impact on Luxembourg’s investment fund industry, which is the second largest in the world, and the banking sector. Moreover, there are connections between investment funds, the insurance sector, and banks. This suggests that severe negative developments in the investment fund industry, including sudden and large redemptions on funds, could potentially have an impact on the banking sector and the overall economy.

Third, changes in tax frameworks could present some challenges in the medium term. The global and European tax transparency initiatives aim to reduce tax evasion and aggressive tax planning. However, the adoption of tax transparency standards, together with the EC’s probes into tax rulings in the EU, and potential taxation changes in other jurisdictions, including the US, could have an impact on Luxembourg’s revenue tax base and render its corporate tax environment less predictable. Luxembourg’s economic prospects could thus be affected, if the country fails to adapt successfully to these potential changes. Nevertheless, the business environment is still expected to remain competitive, supported by the highly skilled labour force and solid institutions.

RATING DRIVERS
Downward pressure on the ratings is unlikely in the absence of a severe shock to Luxembourg’s financial centre, most likely generated by turmoil in financial markets, or a material damage to Luxembourg’s attractiveness for investment. Either of these scenarios could have a significant impact on public finances and the economy.

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

The principal applicable methodology is Rating Sovereign Governments, 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 STATEC (National Institute of Statistics and Economic Studies of the Grand Duchy of Luxembourg), Trésorerie de l'Etat, Banque centrale du Luxembourg (BCL), Eurostat, European Commission, European Central Bank, OECD, IMF, Haver Analytics, DBRS. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited 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 historical default rates published by the European Securities and Markets Authority (“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: Adriana Alvarado, Vice President
Rating Committee Chair: Thomas Torgerson, Senior Vice President
Initial Rating Date: 16 December 2016
Last Rating Date: 16 December 2016

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