DBRS Morningstar Confirms the European Union at AAA, Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the European Union’s (EU or the Union) 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 member states' commitment to the Union, reinforced recently by several measures to mitigate the impact of the Coronavirus Disease (COVID-19) pandemic, has strengthened the cohesion and reduced the fragmentation risk for the EU. The introduction of the one-off tool called Next Generation EU (NGEU) will lead to a sharp rise in the EU's debt, but the Union remains very well positioned to meet its debt service obligations over the long term. The increase in the EU's own resources ceiling (the maximum level of contributions member states can pay to the EU budget) to 2.0% (of which 0.6pp on a temporary basis until 2058) of countries' gross national income (GNI) from 1.2%, along with the introduction of new EU own resources going forward provide significant budgetary headroom to the EU to meet its financial commitments.

The final agreement on the new Multiannual Financial Framework (MFF) for the 2021–27 period has also significantly reduced the remaining uncertainties about the EU budget following the United Kingdom's (UK, rated AA (high) with a Stable trend) departure from the bloc. The UK is expected to continue to pay its share for its participation in some EU programmes and its outstanding commitments (“reste à liquider”), as well as its share of past liabilities not covered by corresponding assets (mostly pensions-related). The loss of the UK's contributions for the 2021-27 period will be offset by higher contributions from the remaining member states.

DBRS Morningstar rates the EU primarily based on its Support Assessment of AAA. This is underpinned by the creditworthiness of its core member states, their strong commitment to the union, and the marginal uplift from the multiple sources of support, particularly from non-core AAA member states. At the same time, the EU’s conservative budgetary management is expected to remain sound despite the introduction of the NGEU. 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 occurs: (1) 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) a rise in anti-EU sentiment due to a lack of cohesion that ultimately results in a material increase in the risk of the EU's dissolution; or (3) although unlikely given its Stable trend, a downgrade of Germany (AAA, Stable).

RATING RATIONALE

The EU’s COVID-19 Crisis Response Demonstrates Ability and Willingness to Counteract Economic Shocks

To face the unprecedented economic and fiscal shock of the coronavirus pandemic, EU authorities have introduced several landmark measures that once again demonstrate the EU’s ability and willingness to counteract economic shocks. Although the new legal framework on own resources has to be ratified by Member States in accordance with their respective constitutional requirements, EU authorities have already agreed on the one-off NGEU tool of EUR 750 billion (in 2018 prices). This agreement follows an already comprehensive set of measures that confirmed the strong commitment of member states to the EU. These comprised the Support to mitigate Unemployment Risks in an Emergency (SURE) programme, of up to EUR 100 billion in financing, the European Stability Mechanism’s (ESM; AAA, Stable) Pandemic Crisis Support in the form of a precautionary credit line, and a new financing facility from the European Investment Bank (EIB; AAA, Stable).

The decision over the NGEU expands previous boundaries related to the EU common debt and central transfers, and reflects stronger cohesion among member states during this crisis. Under the NGEU, the European Commission (EC) will, on behalf of the Union, borrow new EU funds from financial markets and distribute them to member states as nonrepayable funds (up to EUR 390 billion in 2018 prices) and loans (up to EUR 360 billion in 2018 prices) before 2027. DBRS Morningstar will monitor the success of the NGEU program and whether or not this will lead to further EU integration or frictions among member states. These could ultimately arise if the implementation of national recovery programs under the NGEU will deliver lower results than expected, weakening cohesion in the Union.

Given their characteristics as nonrepayable resources, EU debt issued for grants will not be matched by corresponding loans to member states. This represents a key change from the typical back-to-back scheme of EU borrowing programmes. Nevertheless, future repayments for the nonrepayable funds will be financed by the EU's general budget, largely by new EU own resources and/or higher member state budgetary contributions. As part of the agreement on the MFF and Recovery plan a new EU own resource in the form of a contribution based on non-recyclable plastic packaging waste is added to the EU own resources system (pending the ratification of the Own Resources Decision). The EC estimates that annual proceeds of almost EUR 6 billion, in 2021 and 2022, respectively, could be collected from the non-recyclable plastic contribution. Future new EU own resources are expected to be based on a carbon border adjustment mechanism, the revision of the emissions trading system (ETS) scheme, a digital levy, a financial transaction tax and a financial contribution linked to the corporate sector or a new common corporate tax base. Agreements on these other new EU own resources still needs to be achieved and this might require long negotiations among member states.

Support Assessment Remains at AAA Despite France’s Downgrade Because of Uplift From Noncore AAA Countries

With the UK's departure from the Union, the EU’s budget contribution keys now more closely resemble that of euro-area institutions, such as the ESM. DBRS Morningstar has therefore decided to include Spain (rated "A", Stable) in the EU's core member states along with Germany, France (rated AA (high), Stable), and Italy (rated BBB (high), Negative). This decision underscores the capacity and willingness of the largest EU member states to support the institution and does not affect the weighted median rating of the core group that, after the recent one-notch downgrade on France, now stands at AA (high). In DBRS Morningstar's view, despite France's downgrade, the core shareholder capacity, cohesion, and commitment to support the institution remain very strong. Moreover, the Union enjoys the presence of a set of other AAA-rated member states, whose contributions are considered by DBRS Morningstar as sufficient to maintain the EU’s Support Assessment at AAA. Moreover, DBRS Morningstar believes that the overall political commitment to supporting the institution’s key functions remains strong. This reflects the contributions 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 Despite the NGEU 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. While grants will not follow the typical back-to-back scheme, loans under the NGEU and SURE programmes could entail some maturity mismatching with EU bonds. Nevertheless, these loans will be fully repaid by member states and SURE loans also benefit from a guarantee of EU countries totalling EUR 25 billion. Moreover, on a seven-year timescale, the MFF will continue to benefit from established ceilings for the commitment and payment appropriations for annual budgets during that period. This contributes to budgetary 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 scheduled in the EU’s obligations, will continue to be covered by all 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 higher contributions from member states, starting with the next MFF (2028–34) when a large share of the NGEU funds are likely to fall due. 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 gross national income (estimated at EUR 195 billion in 2021) whereas, only with regard to liabilities stemming from the NGEU, member states can be called to provide funds up to an additional 0.6% of the EU’s GNI (estimated at EUR 84 billion in 2021). This appears to be comfortable considering that, under this scheme, principal annual debt repayment will not exceed 7.5% or EUR 29.25 billion of the EUR 390 billion grants. At the same time, debt maturities under NGEU are expected to be spread over a 30-year time horizon. 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.

EU Loan Portfolio Exposure is Rising but Will be Less Geographically Concentrated

The EU’s credit portfolio is rapidly increasing but its exposure will be more diversified than in the past, although Italy and Spain under the NGEU and SURE will be the largest beneficiaries. As of 10 March 2021, loans outstanding, including the Euratom programme, more than doubled at EUR 115.5 billion compared with EUR 51.9 billion at the end of 2019. The large increase was attributable to the introduction of the SURE program with around EUR 62.5 billion in outstanding loans so far. The rest of the loan book comprises mostly EUR 46.8 billion of loans to Ireland (rated A (high), Stable) and to Portugal (rated BBB (high), Stable) under the European Financial Stabilisation Mechanism (EFSM) programme. The EC will likely borrow an additionally EUR 25 billion in 2021, mostly to conclude the SURE funding in addition to the rollover of some debts funded under the EFSM and new funding under the Macro-Financial Assistance (MFA) programme. Details on NGEU debt issuances are not yet available but they are expected to hover around EUR 150 billion to 190 billion annually starting in the second half of 2021 and ending in 2026 with front-loading between 2021 and 2024. DBRS Morningstar will continue to assess the evolution and concentration of the loan portfolio as EU debt rises.

ESG CONSIDERATIONS
Institutional Strength, Governance and Transparency (G) was among key drivers behind this rating action. The EU's institutional framework, reflected also by Treaty commitments and a sound budgetary process, creates strong incentives for core member states to lend support and is a key credit strength.

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.

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 Euros (EUR) unless otherwise noted.

The principal methodology is the Global Methodology for Rating Supranational Institutions https://www.dbrsmorningstar.com/research/374737/global-methodology-for-rating-supranational-institutions%20
(3 March, 2021). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings
(3 February, 2021).

The sources of information used for this rating include EU Investor presentation March 2021, Technical adjustment of the financial framework for 2021 and its Annex (18-12-2020), Guarantee Fund Balance Sheet (31-12-2020), Recovery and Resilience Facility – Grants allocation per Member State, EU Budget 2021, European Commission, IMF WEO, Bloomberg, European Commission Press Release - Commission disburses further €9 billion under SURE to seven Member States (16 March 2021), European Commission Press Release - European Commission raises further €9 billion under SURE via second issuance in 2021 (10 March 2021), 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/375988.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.
Lead Analyst: Carlo Capuano, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: July 11, 2014
Last Rating Date: September 25, 2020

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