DBRS Confirms the European Union at AAA, Stable Trend

DBRS Ratings Limited (DBRS) has today confirmed the Long-Term Issuer Rating of the European Union at AAA and the Short-Term Issuer Rating at R-1 (high). The trend on both ratings remains Stable.

DBRS rates the EU at AAA primarily on the basis of its Support Assessment, which is underpinned by the creditworthiness of its 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 well positioned to manage near-term risks as a result of the strong commitment of its member states to support it on an ongoing basis.

The Support Assessment is based on the overall credit quality of the EU’s core member states and their collective commitment to support the Union. Since the UK referendum in June of last year, DBRS has viewed the UK (AAA with a Stable trend) as less committed to the Union and has removed it from the group of core members. Excluding the UK, the weighted median rating of the core member group — the Federal Republic of Germany (AAA with a Stable trend), the Republic of France (AAA with a Stable trend) and the Republic of Italy (BBB (high) with a Stable trend) — is AAA. This is the case in spite of the downgrade of Italy to BBB (high) from A (low) on 13 January 2017, as DBRS does not believe the recent downgrade of Italy lessens the overall cohesion of the EU. The three core members account for nearly half of all EU contributions and would likely represent well over half of member contributions following a UK’s departure.

Moreover, DBRS believes that the overall political commitment to supporting the institution’s key functions is strong. This has been demonstrated by a number of financial support mechanisms used in response to the financial and sovereign debt crises, as well as by the funds that member states contribute to the EU budget. Furthermore, as established by the founding treaties, EU members share joint responsibility for providing the financial resources required to service the EU’s debt.

The EU does not benefit from any paid-in capital, however, its debt servicing capacity is backed by multiple arrangements that protect creditors. First, all EU borrowings are covered by the EU’s available resources, which this year are 0.85% of the EU’s gross national income (GNI), equivalent to EUR 131.7 billion. These funds can be prioritized for debt service whether or not they have been committed elsewhere. Second, if these amounts are insufficient, member states are legally obligated to provide the funds needed to repay the debt and balance the budget up to a ceiling of 1.20% of the EU’s GNI. If necessary, EU legislation allows member states to contribute more than their share to the EU budget. DBRS expects that if the UK stopped making contributions to the EU budget, the rest of the members would opt to take over the UK’s contribution or reduce the overall budget. However, while net contributors would likely be in opposition to a rise in contributions, budget cuts could be unappealing to the countries that benefit the most from the EU’s transfers. This could lead to a revision of the EU budget rules, with also implications for the upcoming negotiations on the Multiannual Financial Framework (MFF) in 2018.

The EU’s conservative budgetary management further supports the ratings. The Union is not permitted to borrow funds for purposes other than to finance its lending programme. In addition, the MFF provides the general expenditure 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 debt financing typically matching the loans provided in terms of maturity, interest payments and currency. As a result, the EU budget does not incur any interest rate or foreign exchange risks. Moreover, DBRS recognizes the EU’s 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 faces several challenges that could affect the credit quality of its core member states or the degree of support. The UK vote to leave the EU has sparked a period of uncertainty, which will be influenced by the withdrawal negotiations. The deal for leaving the EU must be approved by a qualified majority and negotiations could last beyond March 2019 but only by the unanimous consent of the European Council. In addition, DBRS believes that despite recent electoral defeats, rising support for populist parties could still threaten the cohesiveness of the EU. In this context, the EU faces a trade-off between taking a tough stance on the conditions under which the UK withdraws, with the aim of maintaining unity among the remaining 27 members, and preparing for the possibility of not reaching a deal. Moreover, tensions over migration and border security could prove to be divisive and weaken the commitment of individual members to support the EU. Political relations with Turkey and Russia present an additional challenge to forging common policies within the Union. Finally, the ongoing debate over fiscal austerity and banking rules could undermine the process of integration.

The EU’s highly concentrated lending portfolio represents another challenge. Loans outstanding have increased significantly since 2011, reaching EUR 54.76 billion in April 2017, up from EUR 13 billion in 2010. Debt-to-revenues increased to 41% from 10% over the same period. This rise is mostly attributable to the European Financial Stabilisation Mechanism (EFSM), under which loans totalling EUR 46.8 billion to Ireland (A (high) with a Stable trend) and Portugal (BBB (low) with a Stable trend) account for 85.4% of total loans. 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 European Stability Mechanism (ESM) has assumed primary responsibility for support programmes for Eurozone member states. However, DBRS expects the EU to remain active in capital markets until at least 2026, given the possibility that Ireland and Portugal could extend their EFSM loan maturities.

RATING DRIVERS
The EU’s ratings are driven by the strong, continued political commitment of its member states, which provide the institution with multiple sources of support. However, the EU’s ratings could come under downward pressure if one or more of its core members are downgraded, particularly if the credit deterioration raises concerns about the cohesion of the EU as a whole, or weakens their political commitment to support the EU. If other member states were to propose exiting the EU, this could also put downward pressure on the EU’s ratings.

Notes:
All figures are in Euros unless otherwise noted.

The principal applicable methodologies are Rating Supranational Institutions and 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 European Commission, AMECO, Eurostat, IMF WEO April 2017 and Haver Analytics. 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 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: Carlo Capuano, Assistant Vice President
Rating Committee Chair: Thomas R. Torgerson, Senior Vice President, Global Sovereign Ratings
Initial Rating Date: 11 July 2014
Last Rating Date: 16 December 2016

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