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 Luxembourg’s ample capacity to confront the shock brought on by the coronavirus pandemic and to support the economic recovery without significant weakening of its public finances. The economy contracted in 2020, although only slightly when compared to the severe contractions of many of the country’s euro area peers. Luxembourg’s fiscal deficit and public debt ratio also deteriorated in 2020, reflecting the public response to the crisis and weaker economic activity. 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. The ratings are also supported by its solid institutions and stable political environment, its advanced and wealthy economy, and its strong external position. These credit strengths offset the challenges associated with the country’s small economy with limited diversification, 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 Minor Economic Contraction In 2020, Luxembourg’s Economy Should Rebound In 2021

Luxembourg’s economy performed comparatively well in 2020. Initial estimates point to GDP contraction of 1.3%, limited when compared to 6.5% Euro area drop last year. Despite weak domestic demand – both private consumption and investment contracted in 2020 by over 7% – economic resilience was linked to the strong performance in the country’s high value added service sector exports. The information and communication sector (ICT) alone grew by 17.0% in real terms in 2020. Luxembourg’s economy relies less on the face-to-face hospitality sector and teleworking has helped cushion the shock on the labour market and support incomes. As a result, real GDP reached its pre-crisis level already in the fourth quarter of 2020. The outlook for domestic demand has improved due to the accelerating pace of the vaccination campaign and to the improvement in the health situation that has allowed the relaxation of restrictions. In its recent forecast, the European Commission (EC) forecasts the economy to expand by 4.8% in 2021 and by 3.3% in 2022.

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. DBRS Morningstar does not expect potential changes to the global corporate tax landscape to weaken Luxembourg’s competitive economic model. While international exposures make economic output volatile, risks to the economy from volatile growth rates are overstated. Luxembourg’s exceptionally high GNI per capita and the highest savings 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. Total available fiscal support reached EUR 11 billion in 2020, or around 18.6% of GDP. This included discretionary measures like the short-time work scheme, direct fiscal transfers and indirect liquidity assistance to affected businesses. Measures with direct budgetary effect were limited to 4.8% of GDP in 2020. As a result of the fiscal measures and lower tax revenues, the budget position deteriorated from its 2019 surplus position to a 4.1% of GDP deficit in 2020. The 2021 Stability Programme (SP) expects a 2.0% deficit in 2021 and a near balanced budget by 2023. Fiscal risks could stem from changes to corporate tax policies in Europe and globally. DBRS Morningstar, nonetheless, is of the view that Luxembourg has a proven track record of fiscal prudence and would make the necessary adjustments to offset any shock to budget revenues.

The government debt ratio has increased, but is set to remain at modest levels. The debt ratio increased from 22.0% of GDP in 2019 to 24.9% in 2020 and the SP expects the ratio to peak in 2023 at 28.4%. Excluding COVID-related borrowing the ratio peaks in the same year at 24.4%. Thus the increase reflects the crisis response and the 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 at negative yields.

Risks to Financial Stability Are Contained

Notwithstanding a deteriorating operating environment, Luxembourg banks entered the coronavirus crisis with sound financial positions. Banks are profitable and well capitalised, with comfortable liquidity positions, and good asset quality. House prices have been rising steadily for several years. After growing by 10.1% in 2019, nominal prices increased by 14.5% in 2020. Demand for housing is strong while supply is limited. High house prices have contributed to the rise in household debt, which at 174% 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 above 400% 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 average 5.1% of GDP current account surplus from 2011 to 2020 has been driven by sizeable net exports of financial services. The country also remains a net external creditor, with the net international investment position (IIP) averaging 55.5% 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/382680.

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/381451/global-methodology-for-rating-sovereign-governments (July 9, 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 (February 3, 2021).

The sources of information used for this rating include Luxembourg Ministry of Finance (2021 Stability Programme), Trésorerie de l'Etat, National Institute of Statistics and Economic Studies of the Grand Duchy of Luxembourg STATEC (Conjuncture Flash July 2021), Banque Centrale du Luxembourg BCL (Bulletin 2-2021), Commission de Surveillance du Secteur Financier (CSSF), Eurostat, European Commission (Summer Forecast 2021), European Central Bank ECB), OECD, BIS, IMF, World Bank, UNDP, Global Carbon Project, Social Progress Index, World Economic Forum, Haver Analytics. 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: 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/382679.

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: Nichola James, Managing Director, Co-Head of Sovereign Ratings
Initial Rating Date: December 16, 2016
Last Rating Date: February 12, 2021

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