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 (U.K., rated AAA with a Stable trend by DBRS) 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 anti-EU sentiment ultimately results in a material increase in the risk of the EU’s disintegration.

RATING RATIONALE

Core Members’ Strong Political Commitment to the EU Supports the Ratings

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 (49.6%) and, following the U.K.’s departure from the bloc, they should remain the largest contributors to the Budget.

June 2016, DBRS removed the U.K. from its group of core members following its decision to leave the EU. The anticipated withdrawal of the U.K. 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 U.K. 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’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 (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’s budget does not incur any interest rate or foreign exchange risks.

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 estimated to be 0.90% of the EU’s gross national income (GNI), equivalent to EUR 142.4 billion. The available funds can be prioritized for debt service whether or not they have been committed elsewhere. Furthermore, 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. 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.

Despite recent breakthrough regarding the UK-EU withdrawal agreement, some pressure on the EU budget could arise in the short term, particularly if relations between the U.K. and EU deteriorate further in the wake of ‘no Brexit deal’. However, even in a highly adverse scenario, the EU’s prudent and conservative financial management limits any associated risks. If the withdrawal agreement is ratified, the U.K. government is expected to contribute to the budget until the end of the proposed transition period, scheduled to end on 31 December 2020, with the possibility of reduced contributions thereafter should the UK remain in a customs union with the EU. This reduces significantly the uncertainties over the EU budget. Against this background, DBRS views positively the European Commission proposal to broadly preserve the size of the next MFF in real terms (although including the European Development Fund) despite the U.K. ‘s departure as well as the plan for new expenditures dedicated to border control, security and defense. The impact on the EU budget of the U.K.’s decision to leave the EU should be covered by combination of cuts and higher contributions from remaining members.

Uncertainty Over the EU-U.K. 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 U.K.’s vote to leave the EU has sparked a period of uncertainty, which is influenced by the outcome of the withdrawal agreement along with the rules about the EU-U.K. future relationship. While discussions on a new trade agreement are likely to intensify during the transitional period, the withdrawal deal must be concluded by 29 March 2019, unless an extension of the Article 50 deadline is agreed. Negotiations appear close to a conclusion but DBRS does not rule out that this could derail at the last minute. In order to preserve the unity of the EU among the remaining members and discourage other countries to activate the Article 50, the European Commission has assumed a tough stance in the negotiations and the withdrawal deal also needs to be backed by a qualified majority of the Council as well as by the U.K.’s Parliament. Recent developments point to some difficulties within the U.K. government’s majority in getting the approval.

In addition, DBRS continues to believe that the rising support for populist parties in Europe could 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. These two issues, together with fiscal rules, have been brought to the forefront following the elections in Italy, which saw anti-establishment Five Star Movement and anti-immigration Lega forming a coalition government and assuming a tougher stance on immigration and against fiscal austerity. Italy’s commitment to the EU budget could be questioned if tensions over the respect of fiscal rules between the Italian government and the European Commission (EC) escalate. However, DBRS believes that the legal obligation together with the risk of receiving less funds from the EU minimises uncertainty. Political relations with Turkey and Russia present an additional challenge to forging common policies within the Union.

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 relatively stable over the last few years, loans outstanding amount including Euratom is sizeable at EUR 52.6 billion as of end October 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 89% 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 the 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 U.K.’s departure on the EU budget, Italy’s commitment to the EU budget, 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 October 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: Roger Lister, Managing Director, Chief Credit Officer – Global FIG and Sovereign Ratings
Sovereign Ratings
Initial Rating Date: 11 July 2014
Last Rating Date: 25 May 2018

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