DBRS Confirms Grand Duchy of Luxembourg at AAA, Stable Trend

DBRS Ratings Limited (DBRS) 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, possible changes in tax frameworks in Europe and the US, and potential pressures in the residential real estate market.

The Stable trend reflects Luxembourg’s strong economic fundamentals and DBRS’s view that the challenges Luxembourg faces are manageable. Despite potential risks of financial market volatility, the economy is expected to continue growing at a strong pace. Although the recently-adopted tax reform is set to reduce the fiscal space, public finances are also expected to remain sound, supported by a robust fiscal framework.

The ratings for Luxembourg are supported by its sound public finances. The general government surplus has averaged 1.2% of GDP over the past ten years. The budget position is set to be affected by the tax reform that came into effect at the beginning of 2017, aimed at easing the tax burden on households and firms. Nevertheless, the structural balance is projected to remain above the official target. Luxembourg also exhibits one of the lowest government debt levels in Europe. The gross debt ratio is forecast at 22% of GDP in 2017, 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, Luxembourg’s high income provides the country with an important buffer against shocks. GNI per capita, at USD 75,750 in purchasing power parity, is 1.8 times higher than the Euro area average. After a stronger-than-expected 4.2% in 2016, real GDP growth is forecast at similar pace in 2017 and 2018.

Luxembourg’s external position is also strong. The current account surplus is large at an average of 5.3% 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 36% of GDP on average since 2011. The UK’s departure from the European Union (EU) could affect services exports, but it could equally have a positive impact on Luxembourg from the relocation of financial companies from the UK to Luxembourg. Some large asset managers and insurers have already announced their relocation to the Grand Duchy.

Despite these strengths, Luxembourg faces some credit challenges. Firstly, the degree of economic diversification is limited, as the financial 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.

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. There are also connections between investment funds, the insurance sector, and banks. This suggests that severe negative developments in the investment fund industry could potentially have an impact on the banking sector, especially custodian banks.

Changes in tax frameworks in other jurisdictions could present an additional challenge in the medium term, given the presence of large multinational companies in the country. Luxembourg is committed to the global tax transparency initiatives. However, the adoption of tax transparency standards and potential taxation changes in the US could have an impact on Luxembourg’s corporate revenue tax base. If the country fails to adapt to these changes, Luxembourg’s economic prospects could also be affected. Nevertheless, the business environment is likely to remain competitive, supported by the highly skilled labour force and solid institutions.

Lastly, pressures on the housing market could rise. Residential property prices have risen steadily since 2010 to high levels and ECB models have identified some degree of overvaluation, according to the European Systemic Risk Board. Demand for housing is strong while there are supply constraints. Household debt has also increased over the past decade, but it remains manageable below 60% of GDP, and the debt service-to-income ratio appears robust. DBRS views risks to financial stability as contained.

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 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), Commission de Surveillance du Secteur Financier (CSSF), Eurostat, European Commission, European Central Bank (ECB), and Haver Analytics. 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 and US regulations only.

Lead Analyst: Adriana Alvarado, Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Senior Vice President, Global Sovereign Ratings
Initial Rating Date: 16 December 2016
Last Rating Date: 24 March 2017

DBRS Ratings Limited
20 Fenchurch Street
31st Floor
London
EC3M 3BY
United Kingdom
Registered in England and Wales: No. 7139960

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