DBRS Morningstar Confirms Grand Duchy of Luxembourg at AAA, Stable Trend

DBRS Ratings Limited (DBRS Morningstar) confirmed the Grand Duchy of Luxembourg’s Long-Term Foreign and Local Currency – Issuer Ratings at AAA. At the same time, DBRS Morningstar confirmed the Grand Duchy of Luxembourg’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS

The confirmation of the Stable trend reflects DBRS Morningstar’s view that Luxembourg has significant capacity to face adverse shocks. Despite its exposure to global financial market volatility, the country’s economic prospects remain healthy. After estimated growth of 2.8% in 2019, recent forecasts point to growth still well above that of the Euro area. Reflecting the government’s economic programme, the fiscal surplus is expected to be lower in 2020, but the government debt ratio is set to decline further. Moreover, while house prices and household debt continue to rise, risks to financial stability appear contained, with the banking sector in a sound financial position.

The rating reflects Luxembourg’s sound public finances and fiscal flexibility, 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, rising household debt and potential medium-term pressures in the residential real estate market.

RATING DRIVERS

Given Luxembourg’s strong fundamentals, DBRS Morningstar sees downward pressure on the ratings as unlikely. Nevertheless, downward pressure could stem from a severe shock to Luxembourg’s large international financial centre, most likely generated by sustained turmoil in financial markets. Downward pressure could also come from 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 Prospects of Luxembourg’s Wealthy Economy Are Favourable

Luxembourg’s economy is performing steadily. Real GDP growth has averaged 3.3% over the past five years. In 2019, growth was largely driven by strong private consumption boosted by wage indexation, lower personal taxation and favourable labour market conditions. Fixed investment also posted a rebound in 2019. Looking ahead, forecasts point to a stabilisation in real GDP growth at 2.8%-2.7% in 2020, as projected by the Banque centrale du Luxembourg and the European Commission, or a modest deceleration to 2.4%, as projected by the statistical office STATEC. Despite some uncertainty, growth prospects are sound, with domestic demand expected to remain the main growth driver.

On upside risks to the economic outlook, Luxembourg could continue 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 that could result from a global reassessment of financial risks, sharp changes in monetary policy, or concerns over the global spread of the coronavirus. A global reassessment of risks in financial markets could weigh on economic sentiment and result in reallocations of investment portfolios globally, which could have an impact on investment funds – an important driver of gross value added of the financial sector.

The performance of the financial sector is a major growth driver for Luxembourg. Its investment fund industry, the second largest in the world after the United States, has benefitted from the rise in financial asset valuations globally, partly boosted by the quantitative easing programmes of major central banks since 2010. At the same time, 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 25% of gross value added, 11% of employment, 47% of exports and 18% of budget revenues.

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 firms rests on its highly skilled workforce, competitive tax and legal frameworks, and political stability. The international exposure of Luxembourg economy makes economic output volatile, which might overstate risks to the economy. But, Luxembourg’s exceptionally high GNI per capita – almost twice that of the Euro area average – and the highest saving rate in Europe provide the country with significant buffers against shocks. Together, these considerations support DBRS Morningstar’s assessment of the “Economic Structure and Performance” building block.

Risks to Financial Stability Are Contained

Parts of Luxembourg’s financial sector are interconnected, with banks and investment funds showing interconnectedness. 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 to custodian banks from large but unusual fund redemptions is mitigated by the sizeable stock of liquid assets held by these banks. Moreover, domestically-oriented banks have limited exposure to the investment fund sector. Luxembourg banks are also profitable and well capitalised, their liquidity positions are comfortable, and their asset quality is good. Domestically-oriented banks, however, are exposed to the domestic housing market, as mortgage lending is concentrated in five domestically-oriented banks.

Pressures in the housing market and the household sector could build up over time. House prices have been rising steadily for several years, accelerating since the end of 2018. In Q2-Q3 2019, nominal prices increased by 11.3% compared to the same period the previous year. Demand for housing is strong while supply is limited. Rising prices are affecting housing affordability. Moreover, the IMF, the European Systemic Risk Board (ESRB) and Banque centrale du Luxembourg (BCL) have identified some degree of overvaluation in the housing market.

High house prices have contributed to the rise in household debt in recent years. Household debt has reached 177% of disposable income, among the highest ratios in Europe, close to that in Sweden and below Denmark and the Netherlands. Household debt is largely in the form of mortgages. Moreover, almost 70% of the total stock of mortgages is at variable rates, exposing these mortgage borrowers to increases in interest rates. Some households could also be exposed to income shocks. Nevertheless, new mortgages are increasingly fixed-rate, and the aggregate household net worth position is relatively high at close to 440% of net disposable income.

To increase the resilience of banks in Luxembourg, the Commission de Surveillance du Secteur Financier (CSSF) has activated the countercyclical capital buffer rate, at 0.25% of risk-weighted assets, effective from January 2020 and to be increased to 0.5% from January 2021. Furthermore, the law on the borrower-based macroprudential tools was passed in November 2019, which could be used to contain household indebtedness.

The Political Environment Is Stable, The Budget Position Sound and Public Debt Low

Luxembourg’s political environment is stable, and its level of institutional capacity is high, with governance indicators above the average of OECD countries. At the October 2018 general election, no single political party obtained an absolute majority in the Chamber of Deputies. Following government formation talks, the liberal Democratic Party, the Socialist Workers' Party and the Green Party signed a coalition agreement in December 2018, allowing Prime Minister Xavier Bettel to be reappointed and his centrist coalition to stay in power.

Broad consensus among political parties over sound macroeconomic policies provide the country with policy predictability. The current government aims to maintain Luxembourg’s attractiveness for investment, improve social cohesion, support digital transformation, progress with the economic diversification strategy, foster sustainable finance, and address housing affordability. On fiscal policy, the government remains committed to two main pillars of Luxembourg’s strong fiscal framework – complying with its medium-term objective (MTO) and maintaining the public debt ratio below its 30% of GDP ceiling. The government raised its MTO for the structural budget balance from -0.5% to +0.5% from 2020 to 2022.

As the government implements its economic programme, the fiscal policy stance has turned mildly expansionary. The government has lowered the corporate income tax rate and broadened the bracket to which the reduced corporate tax rate applies. It has also increased excise duties on petrol and diesel, among other measures. Public investment remains at high levels too. The government is also aiming at the simplification of the personal tax regime over the next years. Reflecting the government’s policies, the structural balance has declined from 2.0% in 2018 to an estimated 1.6% in 2019, and is forecast at 0.9% in 2020, as presented in the 2020 Budget.

Risks to the fiscal outlook are largely related to excessive volatility in the financial sector and significantly weaker-than-expected economic growth. In the longer term, risks could also stem from major changes in tax policies in Europe and globally and digital taxation. The government remains committed to tax transparency initiatives and it has implemented the Anti-Tax Avoidance Directives (ATAD) I and II. Tax-related policy changes could add some degree of uncertainty to the country’s corporate tax revenues, given the presence of large multinational companies in the country. Implications of EU-wide probes under state aid rules into past tax rulings could also add some uncertainty. Luxembourg, nevertheless, is still expected to remain an attractive destination for investment.

General government debt remains low. Although the debt ratio almost doubled during the global financial crisis, as the state provided support to some financial institutions, the debt ratio has declined from a peak of 23.7% of GDP in 2013 to an estimated 20.0% in 2019. This is the second lowest ratio in Europe. The government is projecting the ratio to fall to 17.5% by 2023. On a net basis, the public sector has a creditor position of around 42% of GDP, reflecting assets of the general pension insurance scheme, assets of the Intergenerational Sovereign Wealth Fund, and equity stakes in several commercial and non-commercial companies.

The External Position Is Solid and 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 relatively large, at just below 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, it has averaged 45% 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. While Luxembourg is a small economy in a monetary union with limited capacity for external adjustment, Luxembourg’s extensive financial and trade linkages throughout Europe reduce risks and support DBRS Morningstar’s assessment of the “Balance of Payments” building block.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/357738/.

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in euro (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments, which can be found on the DBRS Morningstar website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal 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), Luxembourg for Finance, Eurostat, European Commission, European Central Bank (ECB), OECD, BIS, IMF, World Bank, UNDP, 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: Adriana Alvarado, Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas Torgerson, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: December 16, 2016
Last Rating Date: September 6, 2019

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