DBRS Morningstar Confirms the European Stability Mechanism at AAA, Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the European Stability Mechanism’s (ESM) Long-Term Issuer Rating at AAA and Short-Term Issuer Rating at R-1 (high). The trend on both ratings is Stable.

KEY RATING CONSIDERATIONS
DBRS Morningstar rates the ESM on the basis of its Support Assessment and its Intrinsic Assessment. The Support Assessment is the primary driver of the ESM’s ratings and is at a level equivalent to AAA reflecting the overall credit quality of the ESM’s core shareholders, as well as their collective commitment to support the institution. The ESM’s Intrinsic Assessment, also at a level of AAA, is underpinned by (1) the institution’s high capitalisation; (2) its strong and effective liquidity management; and (3) its preferred creditor status.

RATING DRIVERS
The rating could be downgraded if one or a combination of the following occur: (1) there is a marked deterioration in the creditworthiness of a single core shareholder, particularly if it reflects a material weakening of the cohesion of core member states or of the strength of their political commitment to the Monetary Union; (2) there is a substantial weakening of the ESM's Intrinsic Assessment; or (3) although currently unlikely, both France (AAA, Negative) and Germany (AAA, Stable) are downgraded.

RATING RATIONALE

The COVID-19 Outbreak is Affecting European Economies

The recent Coronavirus Disease (COVID-19) outbreak, together with its large scale economic impact
is severely affecting European economies. The European Commission now forecasts 2020 real gross domestic product (GDP) in the Euro area to contract by 8.7% (Summer 2020 forecast), before growth of 6.1% in 2021, related to governments' support measures and pent-up demand.

While the healthcare crisis has affected all European countries, some have been more impacted than others. To a large extent, DBRS Morningstar highlights that the magnitude of the economic impact seems to reflect the severity of local outbreaks, but also the stringency of the lockdown measures implemented in each country (Europe Macroeconomic Update, July 2020).

European Member States’ Cohesion Has Been Reinforced During the Pandemic

DBRS Morningstar considers that the measures announced by the European Heads of States to respond to the pandemic are positive and signal further cohesion among member states. The ESM is part of the early European response package, providing Pandemic Crisis support to euro member states in the form of a precautionary credit line (ECCL, Enhanced Conditions Credit Line), available for domestic financing of direct and indirect healthcare, cure and prevention-related cost related to COVID-19 of up to 2% of a country's gross domestic product (GDP). This backstop, available for all 19 euro area member states is scaled at a maximum of EUR 240 billion.

While the requirements attached to the provision of these loans have been discussed and agreed beforehand, and member states have been able to request funds since 15 May 2020, no Euro area country has so far tapped into this credit line. DBRS Morningstar considers that the substantial intervention of the European Central Bank (ECB) in the bond markets by providing an extended Asset Purchase Programme (additional EUR 120 billion by year-end 2020) and a specific Pandemic Emergency Purchase Programme (PEPP, up to EUR 1.35 trillion until the end of June 2021) has eased euro area countries' access to financing and has reduced, for the time being, their need to access the ESM's precautionary credit line.

European member states' discussions have recently been focused on the approval of a new temporary recovery instrument called Next Generation EU and scaled at EUR 750 billion. This instrument, made of loans and grants, was approved by European member states on 21 July 2020. DBRS Morningstar views positively for European integration the approval of Next Generation EU. Going forward, DBRS Morningstar will monitor any potential divergences post-COVID-19 in economic, fiscal and debt positions across European countries. Perceptions of divergences might give rise to further Euroscepticism and could bring new challenges to additional European integration.

The Support Assessment Reflects the ESM’s Core Shareholders Commitment to the Institution

DBRS Morningstar defines the ESM core shareholder group as the Federal Republic of Germany (AAA, Stable), the Republic of France (AAA, Negative), the Republic of Italy (BBB (high), Negative), and the Kingdom of Spain (A, Stable). The weighted median shareholder rating of this group, which is the primary driver of the Support Assessment, currently remains at AAA. Nevertheless, this weighted median could be lowered if France's ratings were to be downgraded. DBRS Morningstar, however, recently highlighted in a commentary European Supranational Institutions that lowering the median rating of the core group would not prompt a downgrade of the Support Assessment per se. The ESM's Support Assessment would remain underpinned by the strong commitment of the Euro area member states towards the institution and by additional diversification benefits stemming from AAA governments outside the core group.

DBRS Morningstar also considers that the widening of the ESM’s mission announced as part of a package of reforms to strengthen the Monetary Union indicates a strengthening of its policy mandate and supports DBRS Morningstar’s assessment of the shareholders’ commitment to the institution. However, the ratification process initially scheduled to start quickly after the Eurogroup agreement in principle at the beginning of December 2019 has been delayed. While DBRS Morningstar still considers the ratification of the revised ESM Treaty as the most likely scenario, further discussions might be necessary in coming months to obtain the full buy-in from all shareholders.

The ESM’s Intrinsic Assessment Remains Driven by its Very Strong Capitalisation

The AAA Intrinsic Assessment of the ESM primarily reflects the entity’s capital structure, which consists of €80.55 billion in paid-in capital, serving as a strong backing for the ESM’s bonds and other debt securities, and another €624.25 billion in committed callable capital. The paid-in capital accounts for 16% of the ESM’s total lending capacity of €500 billion, of which €410.1 billion is available for new lending, and 90% of its current loan book of €89.9 billion.

The ESM loan portfolio is characterised by a high degree of concentration in the Hellenic Republic (BB (low), Stable), representing 67% of the total, Spain with 26% and Cyprus (BBB (low), Stable) with 7%. In DBRS Morningstar’s view, the strict existing programme conditionality and review process, the ESM’s preferred creditor status, its strong liquidity management and high capital levels, should continue to mitigate the related credit and concentration risks.

ESM’s Strong Liquidity Management and Preferred Creditor Status Also Support the Institution’s Creditworthiness

Any extension of the ESM lending related to the response to the COVID-19 crisis is unlikely to challenge that assessment as long as other safeguards remain in place. DBRS Morningstar views for instance positively the ESM’s conservative liquidity management practices. Operational guidelines require liquid assets to cover the ESM obligations coming due in the next 12 months. These assets reflect the ESM paid-in capital, which cannot be lent out as part of a financial assistance programme under any of the ESM’s existing instruments. Instead, these funds are invested in highly rated liquid assets, and act as a capital and liquidity cushion.

Finally, DBRS Morningstar considers that the ESM’s preferred creditor status supports the institution’s Intrinsic Assessment by providing additional protection compared to unsecured creditors. DBRS Morningstar, nevertheless, notes that the financial assistance programme for Spain was negotiated by the European Financial Stability Facility (EFSF, AAA Stable) prior to being transferred to the ESM and, therefore, does not benefit from the additional seniority provided to the funding of other programmes.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

RATING COMMITTEE SUMMARY
The main points discussed during the Rating Committee include the COVID-19 crisis and its impact on the ESM’s shareholders’ cohesion and commitment to the institution, the ESM extended role during the COVID-19 pandemic, the ESM’s capitalisation and risk profile.

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

The principal methodology is the Global Methodology for Rating Supranational Institutions (3 March 2020) https://www.dbrsmorningstar.com/research/357589/global-methodology-for-rating-supranational-institutions.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883/.

The sources of information used for this rating include the ESM’s 2019 Annual Report, the EFSF and ESM Investor Presentation (July 2020), the European Commission Summer 2020 forecast. 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.

With Rated Entity or Related Third Party Participation: NO
With Access to Internal Documents: NO
With Access to Management: NO

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 12-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.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/364484/.

Ratings assigned by DBRS Ratings GmbH are subject to EU and U.S. regulations only.

Lead Analyst: Nicolas Fintzel, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: April 4, 2014
Last Rating Date: January 24, 2020

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