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

DBRS Ratings GmbH (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 the shock from the global Coronavirus Disease (COVID-19) pandemic and to support the recovery of the economy. The economic contraction in 2020, particularly from non-financial sectors, is expected to be sharp. Nevertheless, the recession is expected to be less severe than that of the euro area average, and the economy is expected to recover in 2021. Similar to other countries, Luxembourg’s public finances will deteriorate in 2020, reflecting the fiscal response to the crisis and the economic contraction. However, Luxembourg entered the crisis with a strong fiscal position and the government debt ratio is set to remain modest within the country’s own debt ceiling of 30% of GDP.

The ratings reflect Luxembourg’s sound public sector balance sheet 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 and small size of its economy, its vulnerability to external shocks, and its exposure to potential financial stability risks.

RATING DRIVERS

Given Luxembourg’s strong fundamentals, DBRS Morningstar sees a downgrade on the ratings as unlikely. Nevertheless, a downgrade could result from a severe shock to Luxembourg’s large international financial centre, most likely generated by sustained turmoil in financial markets. A downgrade 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

Although Luxembourg’s Economy Has Been Hit by Covid-19, Its Prospects Remain Sound

The economy is on course to post a sharp contraction in 2020, before likely recovering in 2021. Lockdown measures put in place from mid-March to early May to control the spread of the virus, similar to those in Belgium and France, inflicted a severe shock on economic activity, especially construction, non-financial services, and manufacturing. In their latest baseline scenarios, the statistical office STATEC is forecasting real GDP to contract by 6% in 2020, while the Banque centrale du Luxembourg (BCL) is forecasting a contraction of 7.8%. Though sharp, the economic contraction is set to be less severe than the -8.7% euro area average, projected by the European Central Bank and the European Commission. In what resembles a strong rebound, STATEC forecasts growth of 7.0% in 2021, and BCL 7.9% followed by 3.2% in 2022.

A high degree of uncertainty surrounds the economic outlook. The near-term outlook depends to a large extent on containment of the virus, the effectiveness of the economic policy response on the labour market and the corporate sector, and the steady recovery in global financial markets. DBRS Morningstar expects the policy response to the crisis to remain largely effective. In particular, the short-time work scheme, together with Luxembourg’s sectoral structure of the economy with low reliance on the hospitality sector and continued functioning of the financial sector through teleworking, has helped cushion the shock on the labour market and supported incomes. In July, 6% of the labour force was in short-time work compared to around 33% in April 2020. Still, the BCL is forecasting the unemployment rate to increase from 5.4% in 2019 to 6.8% in 2020 and to 7.1% in 2021.

Adding to the uncertainty, some European countries have seen a second-wave resurgence in infection cases over the past two months, though the situation has started to improve in Luxembourg. Moreover, global stock markets are recovering from significant volatility at the beginning of the year. However, severe volatility in stock markets, which may result from a global reassessment of financial risks, could weigh on sentiment and lead to reallocations of investment portfolios globally. Reallocation of investments could have an impact on investment funds – an important driver of gross value added of the financial sector.

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. Nevertheless, 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.

Despite The Shock From Covid-19 on Public Finances, Public Debt Remains Modest

Luxembourg’s ample fiscal space and prudent fiscal policy allowed the government to implement generous measures to support the economy since the start of the pandemic in 2020. Two fiscal packages were adopted, with the first one in March and the second in May. Discretionary measures include the short-time work scheme, direct fiscal transfers to affected businesses, and liquidity assistance for businesses in the form of tax deferrals and loan guarantees. The measures amount to an estimated 17.5% of GDP, with tax deferrals accounting for 7.7% of GDP and state loans and guarantees – to be burden-shared with the financial sector – accounting for 6.1% of GDP. The government has estimated that the direct budgetary impact is 5.5% of GDP.

As a result of the fiscal measures and lower tax revenues, the budget position will deteriorate, but DBRS Morningstar expects government finances to revert to a sound position over the next two years. After almost a decade of fiscal surpluses, the budget position is expected to turn into a large deficit of 8.5% of GDP in 2020, according to early forecasts from the Ministry of Finance in April 2020. So far, the take-up in some of the government’s support programmes has been lower than anticipated, which could lead to a lower than expected deficit. With some of the fiscal measures expiring later this year and the economy starting to recover, the government expects the fiscal deficit to fall to 3.0% in 2021. Nevertheless, the fiscal outlook remains subject to a high degree of uncertainty.

Risks to the near-term fiscal outlook are related to the evolution of the virus, the pace of the economic recovery, and volatility in the financial sector. 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 transposed the Anti-Tax Avoidance Directives (ATAD) I and II into national law. 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. Luxembourg, nevertheless, is expected to remain an attractive destination for investment.

Despite a significant increase, the government debt ratio is set to remain modest. The government is forecasting the debt ratio to increase from 22.1% of GDP in 2019 to 28.7% in 2020 and to 29.6% in 2021. This ratio is still among the lowest in Europe and below the country’s own ceiling of 30% of GDP. Moreover, on a net basis, the public sector is expected to maintain its creditor position, which reached over 40% of GDP in 2019, reflecting the assets from the Pension Reserve Fund, assets of the Intergenerational Sovereign Wealth Fund, and equity stakes in several commercial and non-commercial companies. Luxembourg’s borrowing costs also remain low and recent bond issuances in November 2019 and April 2020 were contracted at negative yields.

Risks to Financial Stability Are Contained

Although their operating environment has deteriorated with the coronavirus crisis, Luxembourg banks entered the crisis with sound positions. Banks are profitable and well capitalised, their liquidity positions are comfortable, and their asset quality is good. In response to the current economic crisis, domestic banks have offered a six-month moratorium on loan repayments for SMEs and the self-employed. Moreover, in March 2020 the ECB Supervisory Board allowed the temporary relief of capital and liquidity buffers for euro area banks to increase their capacity to lend. In Luxembourg, the countercyclical capital buffer remains in place, but it could be released if needed.

In the broader financial sector, parts of Luxembourg’s financial sector are interconnected, with custodian banks and investment funds in particular 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. During the current coronavirus crisis, the authorities have increased monitoring of investment funds. Moreover, domestically-oriented banks have limited exposure to the investment fund sector. Domestically-oriented banks, however, are exposed to the domestic housing market, as mortgage lending is concentrated in five domestically-oriented banks.

House prices and household sector debt have continued to rise. House prices have been rising steadily for several years, accelerating in 2019 and affecting housing affordability. After growing by 10% in 2019, nominal prices increased by 14% Y-o-Y in Q1 2020. Demand for housing is strong while supply is limited. The IMF, the European Systemic Risk Board and BCL have identified a degree of overvaluation in the housing market. Moreover, 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 but below Denmark and the Netherlands. Household debt is largely in the form of mortgages. Almost 70% of the total stock of mortgages is at variable rates, exposing these mortgage borrowers to increases in interest rates. Nevertheless, new mortgages are increasingly fixed-rate, households exhibit a strong asset position at 256% of the debt level, and the aggregate household net worth position is relatively high at close to 433% of net disposable income.

To increase the resilience of banks in Luxembourg, the Commission de Surveillance du Secteur Financier (CSSF) 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, Luxembourg passed the law on the borrower-based macroprudential tools in November 2019, which could be used to contain household indebtedness.

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 external risks and support DBRS Morningstar’s assessment of the ‘Balance of Payments’ building block.

The Political Environment Is Stable

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. The government remains committed to Luxembourg’s strong fiscal framework, including maintaining the public debt ratio below its 30% of GDP ceiling.

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.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/366381.

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in 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 https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments (July 27, 2020).

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 Luxembourg Ministry of Finance (Stability and Growth Programme 2020), Trésorerie de l'Etat, National Institute of Statistics and Economic Studies of the Grand Duchy of Luxembourg STATEC (Note de conjuncture N° 1-2020), Banque centrale du Luxembourg BCL (Bulletin 1-2020, Revue de Stabilite Financiere 2020), Commission de Surveillance du Secteur Financier (CSSF), 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.

With Rated Entity or Related Third Party Participation: YES
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/366379.

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

Lead Analyst: Jason Graffam, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Initial Rating Date: December 16, 2016
Last Rating Date: March 6, 2020

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