DBRS Confirms the European Union at AAA, Stable Trend

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

KEY RATING CONSIDERATIONS

DBRS rates the EU at AAA primarily based on 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 and its creditworthiness is expected to remain extremely robust despite the United Kingdom’s (UK, rated AAA with a Stable trend) expected departure, as a result of the strong commitment and ability of remaining members to support both the EU budget and its obligations.

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 core members’ political commitment to support the EU. Ratings could also face downward pressure if a rise in Euroscepticism ultimately results in a material increase in the risk of the EU’s disintegration.

RATING RATIONALE

Support Assessment reflects a Core Members’ Strong Political Commitment to the EU

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. This is reflected primarily by the AAA weighted median rating of the core member group — the Federal Republic of Germany (rated AAA, Stable trend by DBRS), the Republic of France (AAA, Stable) and the Republic of Italy (BBB (high), Stable). These three core members account for nearly half of all EU contributions (49.5%) and, following the UK’s departure from the bloc, they should remain the largest contributors to the Budget.

In June 2016, DBRS removed the UK from its group of core members following its decision to leave the EU. The anticipated withdrawal of the UK will effectively increase the relative contributions of the remaining members. It is therefore likely that the EU’s budget contribution key will more closely resemble that of euro area institutions such as the European Stability Mechanism (ESM, AAA, Stable). Consequently, as the terms and timing of a UK exit become clearer, DBRS is likely to incorporate Spain (rated A, Stable) as a member of the EU’s core member group. The inclusion of Spain would serve primarily to underscore the capacity and willingness of the largest EU member states to support the institution and would not affect the weighted median rating of the core group (AAA), or the overall support assessment.

DBRS believes that the overall political commitment to supporting the institution’s key functions remains 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’s 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 Benefits From a Conservative Budgetary Management and The De Facto Preferred Creditor Status

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 in 2018 are expected to be 0.91% of the EU’s gross national income (GNI), equivalent to EUR 142.8 billion. These funds can be prioritised 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.

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 Multiannual Financial Framework 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’s budget does not incur any interest rate or foreign exchange risks. Moreover, DBRS recognises the EU’s preferred creditor status — if debtors face payment difficulties, debt repayment to the EU will likely take priority over funds owed to private or other bilateral creditors.

EU Funding Profile Expected to Remain Sound Despite UK’s EU Departure

Although a UK-EU exit transition period depends on a full withdrawal treaty being agreed and ratified, DBRS takes the view that the commitment of the UK government to continue contributing to the budget until end-2020 reduces significantly the uncertainties over the EU budget. Moreover, in DBRS’s view, the EU funding profile is expected to remain sound also post UK withdrawal and it does not rule out the possibility that the UK will continue to contribute to the budget, although with a lower amount. Against this background, DBRS views positively the European Commission (EC) proposal to broadly preserve the size of the next MFF in real terms (although including the European Development fund) despite the UK withdrawal as well as new expenditures for border control, security and defense. The impact on the budget of the UK departure should be covered by combination of cuts and higher contributions from remaining members. While cohesion and agriculture funds are expected to be reduced by around 5% in nominal terms the EC intends raising the member contribution ceiling to 1.29% of the EU’s GNI from 1.20%.

Uncertainty Over the EU-UK Negotiations and Anti-EU Sentiment Remain a Risk to Cohesiveness

The EU faces several challenges that could affect the credit quality of its core member states or the degree of support. The UK’s vote to leave the EU has sparked a period of uncertainty, which is 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 as long as the unanimous consent of the European Council is obtained. 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. DBRS also believes that, despite a more moderate anti-EU stance across members states, the rising support for populist parties in Europe could still threaten the EU’s cohesion, and that tensions over migration and border security could prove to be divisive and weaken the commitment of individual members towards 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 integration process.

Stable but Highly Concentrated Lending Portfolio is Still a Challenge for the EU

The EU’s highly concentrated lending portfolio represents another challenge. Although remaining stable over the last few years, loans outstanding amount is sizeable at EUR 54 billion as of March 2018. A large part of the portfolio is mostly attributable to the European Financial Stabilisation Mechanism (EFSM), under which loans totaling EUR 46.8 billion to Ireland (A (high), Stable) and Portugal (BBB, Stable) account for 86.7% 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, AAA, Stable) has assumed primary responsibility for support programmes to 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 COMMITTEE SUMMARY

The main points discussed during the Rating Committee include: impact of the UK’s departure on the EU budget, next MFF, core shareholders and Euroscepticism.

Notes:
All figures are in Euros unless otherwise noted.

The principal applicable methodology is Rating Supranational Institutions, 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 European Commission, AMECO, Eurostat, IMF WEO April 2018 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: Carlo Capuano, Assistant Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Senior Vice President, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: 11 July 2014
Last Rating Date: 1 December 2017

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