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 confirmation of the Stable trend reflects DBRS’s view that Luxembourg has significant capacity to face potential adverse shocks. Despite risks of financial market volatility, the country’s economic prospects remain robust. Real GDP growth is estimated to have risen to 3.4% in 2017, outpacing Euro area growth, and is projected above 4% in 2018. Moreover, public finances remain sound, despite the tax reform involving tax cuts adopted last year. House prices continue to rise, but risks to financial stability appear contained, with the banking sector in a sound position.

The rating reflects Luxembourg’s sound public finances, its solid institutions and political environment, its advanced and very wealthy economy, and its strong external position. Supported by a solid fiscal framework, Luxembourg has run fiscal surpluses for several years and exhibits one of the lowest government debt ratios in Europe, on average at 22% of GDP over the past five years. The country’s institutions also rank highly in the World Bank governance indicators, above the average of OECD countries. Moreover, Luxembourg’s exceptionally high incomes and savings provide the country with an important buffer against shocks. The country is also a net external creditor, and its current account surplus is large, supported by sizable exports of financial services.

These credit strengths counterbalance the challenges associated with the country’s relatively limited degree of economic diversification, its vulnerability to external shocks, changing tax policies in Europe and the US, and potential medium-term pressures in the residential real estate market. The financial sector accounts for 24% of gross value added, 50% of exports and 18% of budget revenues, and exposes the country to potential risks from turmoil in financial markets. Significant 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. Moreover, pressures on the housing market could rise over time, as residential property prices have been increasing for several years to high levels.

THE ECONOMY IS SET TO CONTINUE GROWING STEADILY
Luxembourg is an attractive investment destination and is among the wealthiest economies in the world. Its attractiveness as a global financial centre and as a domicile for multinational companies rests on its highly skilled workforce, competitive tax and legal frameworks, and political stability. Although the presence of a large international financial sector makes economic output volatile, Luxembourg’s high savings and GDP per capita – estimated to be 2.4 times higher than the Euro area average – provide the country with an important buffer. Moreover, policy efforts to diversify Luxembourg’s small and open economy away from the financial sector to other high-value added industries are ongoing.

The outlook is for steady growth despite some risks. Gross fixed investment is benefitting from cuts to the corporate income tax rate, while disposable incomes are being boosted by wage indexation and lower personal taxation. Real GDP growth is projected to accelerate above 4% in 2018, before moderating towards its 3-3.5% potential in the longer term. Luxembourg is set to benefit from the relocation of financial firms from the United Kingdom to the Grand Duchy as a result of Brexit. In DBRS’s view, downside risks to Luxembourg’s outlook could emerge largely from severe stock market volatility and a global reassessment of financial risks, affecting investment funds and banks and resulting in sizable reallocations of investment portfolios.

HIGH AND RISING HOUSE PRICES COULD POSE A POTENTIAL RISK TO FINANCIAL STABILITY
The performance of the financial sector has been key for Luxembourg. The sector has benefitted from the rise in financial assets, partly boosted by the quantitative easing programmes of major central banks. Luxembourg’s investment fund industry, which is the second largest in the world after the United States, has seen its net assets more than double since 2010 to €4.2 trillion as of December 2017 – equivalent to 75 times Luxembourg GDP. Bank assets have remained broadly stable, after a sharp fall in the aftermath of the global financial crisis. The banking sector, the largest in the EU in relative terms, is mostly internationally-oriented with foreign banks mainly German, French, Chinese, and Swiss banks, and with limited direct links to the domestic economy.

Banks and the insurance sector seem limited interconnected at the domestic level, while banks and investment funds show a higher degree of interconnectedness at the cross-border level. This may suggest that severe negative developments in the investment fund industry could potentially have an impact on parts of the financial sector. Funds, nevertheless, have a wide range of liquidity management tools available, and the risk from large but unusual fund redemptions to custodian banks is mitigated by the sizable stock of liquid assets held by these banks. Moreover, domestically-oriented banks have limited links to the investment fund sector, and their liquidity positions are comfortable, their non-performing loans are low, and profitability is sound. Banks are also well capitalised. However, mortgage lending, which is concentrated in the domestically-oriented banks, has grown rapidly in recent years.

Pressures in the housing market could build up over time. House prices have been rising steadily, by 40% since 2010, reaching high levels and affecting affordability. Demand for housing is strong while supply is constrained. The IMF has estimated that prices are in line with fundamentals, while ECB models have identified some degree of overvaluation. High house prices have contributed to the rise in household debt in recent years. While still moderate relative to the size of the economy, household debt has reached 170% of disposable income. The total stock of mortgages is mostly at variable rates, but new mortgages are largely fixed-rate, reducing risks to rises in interest rates. The debt service-to-income ratio also appears robust and the household net worth position is relatively high at around 440% of net disposable income. DBRS views risks to financial stability as contained.

THE SOLID EXTERNAL POSITION IS INFLUENCED BY THE FINANCIAL SECTOR
Luxembourg’s external position is strong, reflecting persistent current account surpluses and a large net external asset position. Although the current account surplus has been declining since 2007, it remains large at circa 5% of GDP. The surplus is driven by sizable net exports of financial services. The large surplus in the services balance more than offsets both the small goods trade deficit and the large deficit in the income balance. The latter is driven by profit repatriation of multinational companies, financial products placed abroad, and the substantial number of cross-border workers.

The country also remains a net external creditor. While the net international investment position (IIP) can be volatile, the net position averaged 31% of GDP between 2010 and 2016. Higher net FDI and ample liquidity in international markets have bolstered Luxembourg’s external creditor position. The net IIP is mainly accounted for by the large net external asset position of the financial sector. Luxembourg’s international banking system, fund administration industry and the insurance sector hold very large but offsetting asset and liability positions.

PUBLIC FINANCES REMAIN HEALTHY AND THE POLITICAL ENVIRONMENT STABLE
The budget position is expected to remain sound, supporting the country’s fiscal flexibility. The government adopted a tax reform, in effect from January 2017, aiming to ease the tax burden on households and firms and to sustain Luxembourg’s competitive position. Although the tax reform was expected to reduce the fiscal space, the surplus is estimated to have come in at a better-than-expected 1.4% of GDP in 2017, supported by stronger revenues. Despite additional reform measures adopted in the 2018 Budget, the government is expected to continue to post a headline surplus as well as a structural surplus, thus complying with its medium-term objective of a structural balance of -0.5%.

Risks to the fiscal outlook include excessive volatility in the financial sector, and changing tax policies in Europe and the United States. EU-wide probes into tax rulings, the adoption of tax transparency standards, and changes in tax policies in other jurisdictions, could add some degree of uncertainty to the country’s corporate tax revenues in the medium term, given the presence of large multinational companies in the country.

General government debt remains low. Although the debt ratio doubled during the global financial crisis, reflecting state support provided to some financial institutions, the ratio is estimated at 22.9% of GDP in 2017, below the government’s medium-term ceiling of 30%. On a net basis, the public sector has a creditor position of over 40% of GDP, largely reflecting assets of the general pension insurance scheme and equity stakes in several commercial and non-commercial companies. The government debt profile is also favourable. Borrowing is entirely in euros and the average maturity of government debt is comfortable, while general government domestic debt accounts for 67% of total debt.

Luxembourg’s political environment is stable and its level of institutional capacity is high. Broad consensus among political parties over political issues and sound macroeconomic policies provide the country with policy predictability. Since the October 2013 election, the ruling coalition, led by the liberal Democratic Party, together with the Socialist Workers' Party and the Green Party, has seen its popularity decline. The next general election is expected in October 2018 and could see the return to power of the centre-right Christian Social Party (CSV) in a coalition government.

RATING DRIVERS

Given Luxembourg’s strong fundamentals, DBRS sees downward pressure on the ratings as unlikely. Nevertheless, downward pressure could stem from 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 the economy and public finances.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the AAA – AA (high) range. The main points discussed during the Rating Committee include economic growth, effect of changing tax policies, housing market, households’ financial positions, economic volatility, and economic diversification.

KEY INDICATORS

Fiscal Balance (% GDP): 1.6 (2016); 1.4 (2017E); 2.1 (2018F)
Gross Debt (% GDP): 20.8 (2016); 22.9 (2017E); 22.9 (2018F)
Nominal GDP (EUR billions): 53.0 (2016); 56.1 (2017E); 59.4 (2018F)
GDP per Capita (EUR): 91,963 (2016); 93,674 (2017E); 96,487 (2018F)
Real GDP growth (%): 3.1 (2016); 3.4 (2017E); 4.6 (2018F)
Consumer Price Inflation (%): 0.0 (2016); 1.2 (2017E); 1.3 (2018F)
Domestic Credit (% GDP): 483.0 (2016); 478.0 (Sept-2017)
Current Account (% GDP): 4.8 (2016); 4.6 (2017E); 4.8 (2018F)
International Investment Position (% GDP): 34.7 (2016); 26.8 (Sept-2017)
Gross External Debt (% GDP): 7,094 (2016); 6,464 (Sept-2017)
Governance Indicator (percentile rank): 93.3 (2016)
Human Development Index: 0.90 (2015)

Notes:
All figures are in EUR unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/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 at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include Luxembourg Ministry of Finance, Trésorerie de l'Etat, National Institute of Statistics and Economic Studies of the Grand Duchy of Luxembourg (STATEC), Banque centrale du Luxembourg (BCL), Commission de Surveillance du Secteur Financier (CSSF), Eurostat, European Commission, European Central Bank (ECB), OECD, IMF, World Bank, UNDP, 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, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: 16 December 2016
Last Rating Date: 22 September 2017

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