DBRS Morningstar Confirms the European Union at AAA, Stable Trend

DBRS Ratings Limited (DBRS Morningstar) 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

The Stable trend reflects DBRS Morningstar’s view that the EU is well positioned to manage near-term risks. The EU creditworthiness is expected to remain extremely robust despite the United Kingdom’s (U.K., rated AAA with a Stable trend by DBRS Morningstar) expected departure from the EU. This is due to the strong commitment and ability of remaining member states to support both the EU budget and its obligations. With around EUR 13.7 billion, equivalent to around 11% of total national contributions in 2018 to the EU budget, the U.K. is one of the largest net contributors but a combination of lower expenditures and higher revenues from the remaining members is expected to mitigate negative pressure on the budget stemming from the U.K.’s departure from the union.

DBRS Morningstar rates the EU at AAA primarily based on its Support Assessment. This is underpinned by the creditworthiness of its core member states and their strong, continued political commitment to support the EU’s obligations, which provide the institution with multiple sources of support. 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.

RATING DRIVERS

The EU’s ratings could come under downward pressure if one or more of its core members are downgraded or if a marked deterioration in creditworthiness of a single core shareholder occurs, particularly if it 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

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

In June 2016, DBRS Morningstar removed the U.K. from its group of core members following its decision to leave the EU. The U.K.’s expected departure from the bloc 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, rated AAA with a Stable trend). Consequently, as the terms and timing of a U.K. exit become clearer, DBRS Morningstar is likely to incorporate Spain (rated A with a Positive trend) 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 DBRS Morningstar’s overall support assessment.

The Support Assessment is reflected primarily by the AAA weighted median rating of the core member group: the Federal Republic of Germany (rated AAA with a Stable trend), the Republic of France (rated AAA with a Stable trend) and the Republic of Italy (rated BBB (high) with a Stable trend). These three core members account for nearly half of all EU contributions (49.8%) and, following the U.K.’s departure from the bloc, they should remain the largest contributors to the Budget.

DBRS Morningstar believes that the overall political commitment to supporting the institution’s key functions remains strong. This has been demonstrated by the capacity and willingness of the member states to put in place a series of tools and decisions 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 De Facto Preferred Creditor Status

Ratings are further supported by the EU’s conservative budgetary management. The Union is not permitted to borrow funds for purposes other than to finance its lending programmes. 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. 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. This contributes to predictability and discipline.

The EU does not benefit from any paid-in capital. However, its debt-servicing capacity is backed by multiple arrangements that protect creditors. Firstly, all EU borrowings are covered by the EU’s available resources, which in 2019 are estimated to be 0.88% of the EU’s gross national income (GNI), equivalent to EUR 144.8 billion. The available funds can be prioritised for debt service whether or not they have been committed elsewhere. Secondly, member states are legally obligated to provide the funds needed to repay the debt and balance the budget up to the 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 Morningstar 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.

Uncertainty Over the U.K.’s departure and Anti-EU Sentiment Remain a Challenge

The EU faces important challenges, including the high degree of uncertainty regarding a possible disorderly U.K.’s departure from the Union and its impact on the Budget. Even in a no-deal scenario, DBRS Morningstar considers that the EU’s prudent and conservative financial management limits any associated risks. If the withdrawal or a similar 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 depending on the potential future relationship. Conversely, if the U.K. leaves the bloc and stops contributing, the Budget will likely be amended, and the shortfall in contributions will potentially be compensated by the higher funds from the remaining members as well as by a reduction in the expenditure programmes. This could be in line with the European Commission’s 2018 proposal for the next MFF (2021-2027) which assumes the U.K.’s departure as well as new expenditures dedicated to border control, security, defence, digitalisation and innovation. In any case, the U.K.’s obligations to the EU agreed with the financial settlement appear mandatory to set negotiations for the future relationship with the EU, mitigating the impact on the Budget.

DBRS Morningstar acknowledges a risk that rising support for populist parties in Europe could lessen cohesion within the EU. Increased frictions on several matters, including migration, fiscal and foreign policy and border security could prove to be divisive and, in the absence of a reasonable compromise, could ultimately weaken the commitment of individual members towards the EU. In this context, although the EU parliamentary elections in May 2019 resulted in a more fragmented parliament, it remains pro-EU. The centre-right European People’s party (EPP) and the centre-left Socialist and Democratic Party (S&D) lost their traditional combined majority but with the outperformance of Liberals and Greens, Eurosceptic parties cumulatively made modest gains. This reduces risks of a less cohesive Parliament because of potential Eurosceptic positions and paves the way for a possible shared agenda, in particular regarding green investments and immigration. On this matter, the recent change in the Italian government bodes well for a less divisive approach. Nevertheless, progresses might be slow and not supported by all the EU members. Political relations with Turkey and Russia remain an additional challenge to forging common policies within the Union.

A New agreed MFF by end-2019 is Uncertain, While RAL Continues to Increase

Under the Finnish presidency the EC aims to find an agreement on the next MFF (2021-2027) by year end-2019 but this is not as clear cut. The EC’s proposal, which implies a combination of cuts on the agricultural and cohesion funds, might complicate the agreement because of the likely opposition between net receiver and net contributor countries. Moreover, although discussions have made some progress, linking the access to EU funding to the rule of law makes the unanimous consensus potentially more difficult. DBRS Morningstar also notes that the growing amount of “reste à liquider” (RAL), which is the amount of commitments made but not yet paid (stemming mainly from the fact that a commitment can be implemented/paid over several years), might put potentially higher pressure on the EU budget as well as on that of net contributor countries in the future. At the end of 2017 the RAL amounted to EUR 267.3 billion and it is expected to continue to increase going forward. The accumulation of RAL is a natural consequence of the implementation of the EU budget commitments differentiated from payments. However, a factor that influences the current level of the RAL is the delay in implementation of cohesion projects at the start of the current programming period, which is not expected to be recuperated, as well as the change in the decommitment rules for the cohesion funds.

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 is sizeable at EUR 51.6 billion as of end-August 2019. A large part of the portfolio is mostly attributable to the European Financial Stabilisation Mechanism (EFSM), under which loans totalling EUR 46.8 billion to Ireland (rated A (high) with a Stable trend) and Portugal (rated BBB (high) with a Stable trend) account for 90.8% of total loans. Notwithstanding the relatively high loan concentration, financial assistance programmes are subject to strict policy conditionality, which mitigates credit risks. Moreover, the EU operates typically with very sizeable cash balances that exceed maturing debt. Over the medium term, DBRS Morningstar projects EU debt to decline as the European Stability Mechanism has assumed the primary responsibility for support programmes to Eurozone member states. However, DBRS Morningstar 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 and cohesiveness among the member states, progress over the next MFF.

KEY INDICATORS

EU GNI (EUR Billions): 15,871(2018); 16,446 (2019F); 16,988 (2020F)
Own Resource ceiling (EUR Billions): 190.5 (2018); 197.4 (2019F); 203.9 (2020F)
Own Resource (EUR billions): 142.4 (2018); 144.8 (2019F); 151.6 (2020F)
Headroom on Own Resources Ceiling (EUR billions): 48.1 (2018); 52.6 (2019F); 52.3 (2020F)
Total expenditures (EUR billions): 144.8 (2018); 148.5 (2019F); 153.6 (2020F)
Total Commitment Appropriations (% GNI): 1.02 (2018); 1.00 (2019F); 0.99 (2020F)
Total Payment Appropriations (% GNI): 0.98 (2018); 1.01 (2019F); 1.01 (2020F)
Margin Available (% GNI): 0.22 (2018); 0.19 (2019F); 0.19 (2020F)
Own Resource Ceiling (% GNI): 1.20 (2018); 1.20 (2019F); 1.20 (2020F)

Notes:
All figures are in Euros (EUR) unless otherwise noted.

The principal applicable methodology is Rating Supranational Institutions, which can be found on the DBRS Morningstar 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 2019, ECA (European Court of Auditors) and Haver Analytics. DBRS Morningstar 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 Morningstar had no access to relevant internal documents for the rated entity or a related third party.

DBRS Morningstar 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 Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar 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, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign
Initial Rating Date: July 11, 2014
Last Rating Date: April 12, 2019

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