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.

KEY RATING CONSIDERATIONS

The confirmation of the Stable trend reflects DBRS’s view that Luxembourg has significant capacity to face adverse shocks. Despite risks of financial market volatility, the country’s economic prospects and public finances remain robust. Real GDP growth is projected at 3.9% in 2018, outpacing that of the Euro area. Moreover, the budget position is expected to remain sound through the elections and formation of a new government later this year. House prices continue to rise, but risks to financial stability appear contained, with the banking sector in a sound financial position.

The rating reflects Luxembourg’s sound public finances, its solid institutions and stable political environment, its advanced and very wealthy economy, and its strong external position. These credit strengths offset 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.

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 sustained 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 RATIONALE

The Political Environment Is Stable and Public Finances Remain Healthy

Despite the uncertain results from the coming elections, Luxembourg’s political environment is set to remain stable. The country’s level of institutional capacity is high, with governance indicators above the average of OECD countries. The next general election is scheduled for 14 October 2018. The ruling coalition, led by the liberal Democratic Party (DP), together with the Socialist Workers' Party (LSAP) and the Green Party, has seen its popularity decline since the October 2013 election. At the same time, support for the centre-right Christian Social Party (CSV) has risen. No party is expected to obtain a majority in Parliament and thus a coalition government is the most likely outcome.

Broad consensus among political parties over sound macroeconomic policies provide the country with policy predictability. The tax reform entered into force in 2017, aimed at easing the tax burden on households and firms and at preserving Luxembourg’s competitive position, was expected to reduce the fiscal space. Nevertheless, the surplus came in at a better-than-expected 1.5% of GDP, supported by strong revenues, mainly from corporate income taxes. A technical budget for the first four months of 2019 is set to be presented in the autumn until a formal budget for the full year is agreed by the new government. DBRS expects Luxembourg 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% and supporting its fiscal flexibility.

Risks to the fiscal outlook include excessive volatility in the financial sector as well as changing tax policies in Europe and the US, EU-wide probes under state aid rules into past tax rulings, and the adoption of tax transparency standards. Tax-related changes 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, reflecting a solid fiscal framework. Although the debt ratio doubled during the global financial crisis, as the state provided support to some financial institutions, the ratio was 23.0% of GDP in 2017, the second lowest ratio in Europe and 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, 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.

Luxembourg’s Wealthy Economy Is Set to Grow Robustly in The Medium Term

The economic outlook is for robust growth. Real GDP growth in 2017 has been estimated at a lower-than-expected 2.3%, but this could be revised upwards. Cuts to the corporate income tax rate have fostered gross fixed investment, while wage indexation and lower personal taxation have boosted disposable incomes, supporting consumption. Favourable conditions in financial markets and the labour market are also supportive. Growth is projected to accelerate close to 4% in 2018, before moderating towards its 3-3.5% potential in the longer term.

On upside risks to the economic outlook, Luxembourg is set to benefit from the relocation of financial firms from the United Kingdom to the Grand Duchy as a result of Brexit. Conversely, downside risks to the outlook could emerge from severe volatility in stock markets, a global reassessment of financial risks, or sharp changes in monetary policy conditions. These scenarios could weigh on economic sentiment and also have an impact on investment funds – an important driver of gross value added of the financial sector – and result in reallocations of investment portfolios globally.

The performance of the financial sector has been a major growth driver for Luxembourg. Its investment fund industry has benefitted from the rise in financial assets globally, 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. This raises the question of whether the expected tightening of monetary policy could have an impact on the fund industry. A recent IMF scenario analysis suggests that funds could suffer net outflows and redemptions but only under a severe stress situation of significant and abrupt tightening of monetary conditions within a short period.

Luxembourg remains 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 firms rests on its highly skilled workforce, competitive tax and legal frameworks, and political stability. Although the large international financial sector makes economic output volatile, Luxembourg’s exceptionally high GNI per capita – almost twice that of the Euro area average – and with the highest saving rate in Europe provide the country with significant buffers against shocks.

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 financial sector accounts for 24% of gross value added, 50% of exports and 18% of budget revenues (for further details, please see DBRS Illustrative Insight newsletter entitled “Economic Diversification of Luxembourg”, available at www.dbrs.com).

Risks to Financial Stability Are Contained

Parts of the financial sector are interconnected. Banks and investment funds show interconnectedness at the cross-border level. This may suggest that severe and sustained negative developments in the investment fund industry could potentially have an impact on parts of the financial sector. Nevertheless, funds 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 sizeable stock of liquid assets held by these banks. Moreover, domestically-oriented banks have limited links to the investment fund sector. Banks are also profitable and well capitalised, their liquidity positions are comfortable, and their non-performing loans are low. Domestically-oriented banks, however, are exposed to the domestic housing market, as mortgage lending is concentrated in five banks.

Pressures in the housing market and the household sector could build up over time. House prices have risen steadily by 45% since 2010. Rising prices could affect affordability. The IMF has estimated that prices are in line with fundamentals, while the European Central Bank (ECB) and Banque centrale du Luxembourg (BCL) have identified a modest degree of overvaluation. Demand for housing is strong while supply is constrained.

High house prices have contributed to the rise in household debt in recent years. Household debt has reached a high level of 172% of disposable income. Moreover, almost 70% of the total stock of mortgages is at variable rates, exposing many households to increases in interest rates. But new mortgages are increasingly fixed-rate. Some households could also be exposed to income shocks. As a mitigating factor, the aggregate household net worth position is relatively high at close to 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 around 5% of GDP. The surplus is driven by sizeable net exports of financial services. The country also remains a net external creditor. While the net international investment position (IIP) can be volatile, the position averaged 33% of GDP since 2010. 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.

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 general elections, economic growth, the financial sector, the housing market, and household debt.

KEY INDICATORS

Fiscal Balance (% GDP): 1.5 (2017); 1.7 (2018F); 2.4 (2019F)
Gross Debt (% GDP): 23.0 (2017); 22.7 (2018F); 22.1 (2019F)
Nominal GDP (EUR billions): 55.4 (2017); 58.3 (2018F); 61.2 (2019F)
GDP per Capita (EUR): 93,718 (2017); 95,390 (2018F); 97,985 (2019F)
Real GDP growth (%): 2.3 (2017); 3.9 (2018F); 4.0 (2019F)
Consumer Price Inflation (%): 1.7 (2017); 1.3 (2018F); 1.7 (2019F)
Domestic Credit (% GDP): 472.1 (2017); 451.6 (Q1 2018)
Current Account (% GDP): 5.0 (2017); 5.4 (2018F)
International Investment Position (% GDP): 42.3 (2017); 31.7 (Q1 2018)
Gross External Debt (% GDP): 6,309 (2017); 6,240 (Q1 2018)
Governance Indicator (percentile rank): 93.3 (2016)
Human Development Index: 0.9 (2015)

Notes:

All figures are in EUR unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Forecasts based on National Institute of Statistics and Economic Studies of the Grand Duchy of Luxembourg (STATEC). 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: 9 March 2018

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