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 economy is expected to have contracted sharply in 2020, although less severely than many of its euro area peers. Luxembourg’s public finances also deteriorated 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 and below the country’s own debt ceiling of 30% of GDP.

The ratings reflect Luxembourg’s sound public sector balance sheet and fiscal flexibility. Also, 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 the 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 of 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 on public finances.

RATING RATIONALE

Following the 2020 Contraction, the Luxembourg Economy is Expected to Rebound 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. The economy contracted by 7.4% quarter-over-quarter in the second quarter. The easing of restrictions across Europe over the summer led to an 12.4% third quarter expansion. The recovery was widespread across various sectors of the Luxembourg economy. In its December 2020 update, Luxembourg’s statistical agency (STATEC) forecast that the economy contracted by 3.5% in 2020, considerably less than the euro area’s 6.8% contraction.

The 2021 outlook depends to a large extent on containment of the virus, the administration of the vaccines, the effectiveness of the economic policy response on the labour market and on the corporate sector, and the steady recovery in global financial markets. DBRS Morningstar expects the vaccine rollout to accelerate during the year and the policy response to the crisis to remain largely effective. Moreover, Luxembourg’s economy relies less on the face-to-face hospitality sector and more on the financial sector, and teleworking has helped cushion the shock on the labour market and support incomes. STATEC forecasts the economy to rebound by 4.0% in 2021.

Luxembourg is an attractive investment destination and is among the wealthiest economies in the world. Due to its highly skilled workforce, competitive tax and legal frameworks, and political stability, Luxembourg is a global financial centre. While international exposures make economic output volatile, risks to the economy from volatile growth rates are overstated. 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 positive 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. Fiscal support included discretionary measures like a short-time work scheme, direct fiscal transfers to affected businesses, and liquidity assistance for businesses in the form of tax deferrals and loan guarantees. As a result of the fiscal measures and lower tax revenues, the budget position deteriorated to a 7.4% deficit in 2020. The government expects a 2.7% deficit in 2021 and for it to converge towards balance thereafter. Fiscal risks could stem in the coming years from major changes in tax policies in Europe and globally.

Despite a significant increase, the government debt ratio is set to remain modest. The 2021 Draft Budget forecasts the debt ratio to increase from 22.1% of GDP in 2019 to 27.4% in 2020 and to 29.4% in 2021. Though increasing rapidly, the increase reflects the crisis response, and this ratio remains 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, 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 were contracted at negative yields.

Risks to Financial Stability Are Contained

Although their operating environment has deteriorated, Luxembourg banks entered the coronavirus 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 offered a six-month moratorium on loan repayments for SMEs and the self-employed. Value-added in the financial sector was down only 0.6% from a year earlier in the third quarter of 2020.

House prices have been rising steadily for several years. After growing by 10% in 2019, nominal prices increased by 13.6% year-over-year in the third quarter of 2020. Demand for housing is strong while supply is limited. High house prices have contributed to the rise in household debt, which at 177% of disposable income remains among the highest ratios in Europe. 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, there is little reason to expect a sudden increase in interest rates in the coming years. Safe-guarding the financial system from rising real estate prices is household wealth, with a net worth position close to 433% of net disposable income. These considerations support DBRS Morningstar’s positive assessment of the ‘Monetary Policy and Financial Stability’ building block.

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. The current account surplus of 3.8% of GDP in 2020 is driven by sizeable net exports of financial services. The country also remains a net external creditor, with the net international investment position (IIP) averaging 56% of GDP since 2011. 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, the country’s extensive financial and trade linkages throughout Europe reduce external risks and support DBRS Morningstar’s positive 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 can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at: https://www.dbrsmorningstar.com/research/373262.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/373645.

EURO AREA RISK CATEGORY: LOW

Notes:
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.

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 (July 27, 2020). Other applicable methodologies include DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262 (February 3, 2021).

The sources of information used for this rating include Luxembourg Ministry of Finance (2021 Draft Budgetary Plan), Trésorerie de l'Etat, National Institute of Statistics and Economic Studies of the Grand Duchy of Luxembourg STATEC (Conjuncture Flash January 2021), Banque Centrale du Luxembourg BCL (Bulletin 1-2020, Revue de Stabilite Financiere 2020), Commission de Surveillance du Secteur Financier (CSSF), Eurostat, European Commission (Autumn 2020), 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. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/373644.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.
Lead Analyst: Jason Graffam, Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas Torgerson, Managing Director, Co-Head of Sovereign Ratings
Initial Rating Date: December 16, 2016
Last Rating Date: September 4, 2020

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