DBRS Morningstar Confirms the European Union at AAA, Stable Trend

DBRS Ratings GmbH (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’s recent decisions strengthen Member States’ commitment to the Union and compensate for the risks arising from the large increase in EU debt expected in the next few years. To mitigate the impact of the Coronavirus Disease (COVID-19) pandemic, the European Council agreed in July on a one-off tool called Next Generation EU (NGEU) that in DBRS Morningstar’s view reinforces political cohesion, reduces EU disintegration risk and paves the way for EU fiscal capacity. The additional EU funds should work towards helping to reduce potential economic divergences amplified by the pandemic on European economies, and to alleviate the social costs associated with this shock that could otherwise undermine political stability and ultimately member states’ commitment to the Union.

However, this will come at the cost of a significant rise in EU debt in coming years. EU borrowing to fund NGEU non-repayable resources to member states will be supported by future EU own budget resources, yet to be precisely articulated, to cover debt redemptions. This makes the introduction of new own resources pivotal to avoid an increase in the member states contributions in the future. DBRS Morningstar gains comfort from the fact that the EU’s new debt will have a long maturity, giving ample time for member states to agree on new resources and from a new and temporary safeguard on the EU own resources ceiling (maximum level of contributions Member States can pay to the EU budget) that will strengthen the EU’s repayment capacity to the NGEU debt.

At the same time, the agreement on the new Multiannual Financial Framework (MFF) 2021-2027 reduces the uncertainty over the adverse impact of the UK’s departure from the bloc on the EU Budget. However, a weaker EU recovery in the absence of a future free trade deal with the UK remains a possibility. The European Council agreed to increase the permanent own resource ceiling to 1.40% of Gross National Income (GNI) from 1.20% of GNI and to establish a reserve fund to counter adverse implications resulting from the UK’s departure. Moreover, the increase in the contribution from remaining members will also help compensate for the shortfall resulting from the loss of the UK's contribution to the Budget. Although the absence of a free trade deal at the end of the transition period might weigh on the EU’s economic recovery, DBRS Morningstar anticipates that the UK will remain committed to payment of the agreed financial settlement with 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. At the same time, the EU’s conservative budgetary management is expected to remain sound despite the NGEU’s introduction. Multiple arrangements that protect creditors remain in place as well as the institution’s de facto preferred creditor status.

RATING DRIVERS

The EU’s ratings could be downgraded if one or a combination of the following occur: (1) there is a marked deterioration in 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 EU; (2) although currently unlikely, if both France (AAA, Negative) and Germany (AAA, Stable) are downgraded; (3) should there be a rise in anti-EU sentiment due to lack of cohesion that ultimately results in a material increase in the risk of EU break-up.

RATING RATIONALE

The EU’s COVID-19 Crisis Response Reduces EU Fragmentation Risk

To face the unprecedented threat of the pandemic, EU authorities have introduced several landmark measures that demonstrate once again the EU’s ability and willingness to counteract economic shocks. However, additional details need to be decided and legislated. On 21 July 2020, the EU Council agreed on a new MFF of EUR 1,074 billion (in 2018 prices) and on the one-off NGEU tool of EUR 750 billion (in 2018 prices). This agreement follows an already comprehensive set of measures implemented that confirmed the strong commitment of member states to the EU. These include the Support to Mitigate Unemployment Risk in an Emergency (SURE) programme up to EUR 100 billion, the ESM’s (AAA, Stable trend) Pandemic Crisis support in the form of a precautionary credit line and a new financing facility from the European Investment Bank (EIB, AAA, Stable Trend). The July decisions, however, are still subject to EU parliamentary consent and national parliament ratification, but they are expected to be introduced without significant changes. Nevertheless, frictions with regard the Rule of Law conditionality as well as the role of the EU parliament are likely to occur and audit rights of the European Court of Auditors (ECA) on the NGEU are still not clear.

The Council decision will cross the previous red lines related to EU common debt and central transfers, reflecting stronger cohesion. Under the NGEU, the European Commission (EC) will, on behalf of the Union, borrow from financial markets new EU funds and distribute them to Member States as non-repayable funds (up to EUR 390 billion) and loans (up to EUR 360 billion) until 2027. In DBRS Morningstar’s view, these decisions reinforce cohesion and solidarity, represent a further step towards further integration, and reduce the EU’s fragmentation risk (see COVID-19: EU Crisis Response a Step Forward, But Many Challenges Ahead). The high degree of economic interdependence, the benefit of a large economic single European market, as well as the lingering threat of Euroscepticism have played a major role in the agreement. Conversely, a tepid or slow response, in DBRS Morningstar’s view, would have undermined the perception of member states’ commitment towards the EU and intensified the economic and social costs that the coronavirus pandemic will inevitably cause.

Higher Own Resource Ceilings Mitigate the Risk Stemming From the Sizeable Increase in the Debt

Although not all the details have been decided, a large part of new EU debt will likely not be matched by corresponding loans. This is because under the NGEU programme up to EUR 390 billion will be distributed as non-repayable resources. While this will limit the burden on European countries’ general government debt, it will also represent a key change compared with the typical back-to-back scheme of EU borrowing programmes. NGEU loans will be repaid by member states as in other programs that are back-to-back loans, but future EU budget repayments for the non-repayable part will be paid by the general budget, financed largely by new own resources . A contribution on non-recyclable plastic will become effective in January 2021, but carbon border adjustments, a revision on the emissions trading systems (ETS) scheme, a digital levy, and a financial transactions tax still need to be agreed and might require long negotiations. Should this not be sufficient, DBRS Morningstar is of the view that member states will provide higher budgetary contributions in the future. In the meantime, EU countries have agreed on a temporary increase of 0.6% of Member States’ GNI until 2058 of the own resources ceiling estimated at around EUR 84 billion per year (measured with 2019 EU GNI) specifically earmarked for the sole purpose of covering all liabilities of the Union resulting from its borrowing under NGEU.

The UK’s Exit Will Prompt Changes But Does Not Affect Member States’ Commitment to the Union

Beyond the impact of the coronavirus outbreak, the EU faces additional challenges, including the high degree of uncertainty regarding the new future relationship with the UK after the transition period. According to the Withdrawal Agreement, the UK is expected to contribute to the EU budget until 31 December 2020 and to continue to pay its share of the payments deriving from commitments of the 2014-2020 period (and previous periods – the “RAL - Reste A Liquider”) as well as its share of liabilities not covered by corresponding assets (mostly pensions). During recent weeks, negotiations on the future relationship have become more complex and both parties seem to rule out an extension of the transition period. DBRS Morningstar is of the view that the UK will continue to contribute to the EU budget as a third country when the transition period expires, albeit in a reduced amount. The UK shortfall is expected to be compensated for by the permanent increase in the own resources ceiling to 1.40% of EU27 GNI from the current 1.20% of EU28 GNI, and by higher contributions from remaining member states.

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

DBRS Morningstar primarily rates the EU based on the Support Assessment that reflects the creditworthiness and the commitment of the core member states. In June 2016, DBRS Morningstar removed the UK from its group of core members following its decision to leave the EU. The UK’s departure from the bloc will effectively increase the relative contributions of its remaining 27 members. It is, therefore, likely that the EU’s budget contribution keys starting from 2021 will more closely resemble that of euro area institutions such as the ESM. Consequently from the next annual budget, DBRS Morningstar is likely to incorporate Spain (rated “A” with a Stable 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 (currently at 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 Negative trend) and the Republic of Italy (rated BBB (high) with a Negative trend). These three core members account for nearly half of all national contributions (49.0%) to the EU budget and, starting with the 2021 EU Budget, they are likely to remain the largest contributors to the EU’s budget.

DBRS Morningstar believes that the overall political commitment to supporting the institution’s key functions remains strong. This reflects the contribution of EU member states to the EU’s budget and, as established by the founding treaties, the shared joint responsibility for providing the financial resources required to service the EU’s debt.

Sound Budgetary Management and De Facto Preferred Creditor Status Support the Ratings

The ratings are further supported by the EU’s conservative budgetary management, which is expected to remain sound despite the sizeable increase in the debt mainly resulting from the NGEU. EU grants and guarantees will not benefit from the back-to-back loan borrowing schemes but this will not alter the conservative budgetary management of the EU. Loans under the NGEU and SURE programmes, instead, could entail some maturity mismatching, but they will be fully repaid by member states. Moreover, on a seven-year timescale, the MFF will continue to benefit from established 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. All EU borrowings, despite the significant increase in the EU’s obligation will continue to be covered by the EU’s available resources. These can be prioritised for debt service whether or not they have been committed elsewhere. The EU budget is expected to benefit from new EU own resources and/or by higher contributions from members states, in particular starting with the following MFF (2028-2034) when a large share of the NGEU is likely to be repaid. Moreover, member states can be called on to provide the funds needed to repay the debt and balance the budget up to the permanent ceiling of 1.40% of the EU’s GNI (estimated at EUR 196 billion in 2021) whereas only with regard to liabilities stemming from the NGEU, member states can be called to further provide funds up to 0.6% of EU’s GNI (estimated at EUR 84 billion). This appears to be comfortable considering that under this scheme, principal debt repayment will not exceed 7.5% of the EUR 390 billion expenditures per year, or EUR 29.25 billion, giving ample time for EU member states to agree on levying additional resources in the future. However, DBRS Morningstar will continue to assess the evolution of the decisions as details emerge. 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.

As the NGEU Kicks in, EU Loan Portfolio’s Exposure Will Rise but Will be Less Concentrated

The EU’s credit portfolio has remained broadly stable over the last few years but the EU’s recent decisions will result in a substantial increase in the coming years. As of August 2020, loans outstanding, including the Euratom programme, were already large at EUR 51.9 billion. Most of it was attributable to the European Financial Stabilisation Mechanism (EFSM) programme, under which total loans of EUR 46.8 billion to Ireland (rated A (high) with a Stable trend) and to Portugal (rated BBB (high) with a Stable trend) accounted for 90.1% of the total portfolio. This reflected a high concentration risk that will now decline as new loans under the SURE and NGEU programmes start to be extended to EU members. The EC will likely borrow around EUR 40 billion and EUR 50 billion in 2020 and in the first half of 2021, respectively for the SURE programme, while average NGEU debt issuances are expected to hover around EUR 150-190 billion starting in the second half of 2021 and ending in 2026 with a front-loading between 2021 and 2024. Because of the large size of the NGEU programme, the EU's exposures to Italy and Spain, highly affected by the pandemic, is likely to be elevated in the years to come. DBRS Morningstar will assess the evolution and the concentration of the loan portfolio as EU debt rises.

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 EU authorities decisions to counteract the impact of the COVID-19 on the EU, risks arising from the EU debt increase, and commitment to the EU and creditworthiness of the core shareholders.

Notes:
All figures are in 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 EU Investor presentation September 2020, Technical adjustment of the Financial Framework for 2020, Guarantee Fund Balance Sheet (30-06-2020), Council Regulation (EU) 2020/672 of 19 May 2020, EU Budget 2020, European Commission, Long-term forecast of future inflows and outflows of the EU Budget 2021-2025, European Council July 21 2020 conclusions, IMF WEO, 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/367275

Ratings assigned by DBRS Ratings GmbH are subject to EU and U.S. 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 Ratings
Initial Rating Date: July 11, 2014
Last Rating Date: April 3, 2020

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