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, their collective commitment to support the institution as well as the additional diversification benefits stemming from AAA governments outside the core group. 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 ratings 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; or (2) there is a substantial weakening of the ESM's Intrinsic Assessment.

RATING RATIONALE

COVID-19 Has Severely Affected European Economies but Member States’ Cohesion Has Been Reinforced Since the Beginning of the Pandemic

The Coronavirus Disease (COVID-19) pandemic, together with its large scale economic impact has been severely affecting European economies. While the Euro area gross domestic product (GDP) contracted by 6.5% in 2020, the European Commission currently expects the area's GDP to rebound by 4.8% in 2021 and 4.5% in 2022 (Summer 2021 forecasts), supported by governments' fiscal measures, pent-up demand, and the steady vaccination rollout throughout Europe. Going forward, the full extent of the economic impact on European economies will continue to remain intrinsically linked to the healthcare situation and the potential spread of vaccine-resistant variants.

DBRS Morningstar considers that the measures announced by the European Heads of States to respond to the COVID-19 pandemic are positive and signal further cohesion among member states. The ESM has been 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 costs 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 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 (APP, EUR 120 billion until December 2020, EUR 20 billion per month thereafter) and a specific Pandemic Emergency Purchase Programme (PEPP, up to EUR 1.85 trillion until the end of March 2022) has eased euro area countries' access to financing and reduced their need to access the ESM's precautionary credit line.

European member states have also agreed in November 2020 on implementing the Next Generation EU (NGEU) programme, providing grants and loans to European member states of up to EUR 750 billion. DBRS Morningstar views this approval positively for European integration and all European institutions. To boost their recovery, EU countries are currently committed to taking benefits of the grants under the NGEU, through the delivery of various reforms. Going forward, DBRS Morningstar also expects several member states to use NGEU loans, depending market conditions and potential changes in yield spreads. DBRS Morningstar will continue to 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’ Creditworthiness and Their Commitment to the Institution

DBRS Morningstar defines the ESM core shareholder group as the Federal Republic of Germany (AAA, Stable), the Republic of France (AA (high), Stable), 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 stands at AA (high), reflecting France's rating. Despite the AA (high) weighted median core shareholders' rating, DBRS Morningstar considers that the ESM's Support Assessment remains at AAA. The ESM's Support Assessment remains 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. The ESM reform was formally agreed by the Eurogroup on 30 November 2020, therefore extending further the role of the institution going forward.

New missions include (1) the provision from 2022 of a backstop to the Single Resolution Fund (SRF) of up to EUR 68 billion in the form of a credit line; (2) a reinforced role in designing and monitoring future country programmes together with the European Commission; (3) a greater role for the ESM outside the programmes, providing macroeconomic and financial expertise; (4) the improvement of the ESM precautionary credit lines; and (5) the commitment in the ESM Treaty by member states to include single-limb collective action clauses in future sovereign bonds issuances (from 2022). The ratification of the ESM Treaty by member states is now expected to occur by the end of 2021.

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

The ESM’s Strong Liquidity Management and its Preferred Creditor Status Continue to Support its 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. The ESM is moreover building a responsible investment framework to include ESG criteria within its investment processes.

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 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.

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. Public finance statistics reported on a general government basis unless specified.

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

The sources of information used for this rating include the ESM Investor Presentation (July 2021), the ESM 2020 annual report, the ESM carbon footprint report, the European Commission Summer 2020 forecasts. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, this is an unsolicited credit 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. 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/382041.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Nicolas Fintzel, Senior Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head of Global Sovereign Ratings
Initial Rating Date: July 27, 2012
Last Rating Date: January 22, 2021

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