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 by several measures taken 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 Next Generation EU (NGEU) programme is leading to a sharp rise in the EU's debt which stood at around EUR 206 billion (1.5% of EU27 GNI) as of September 2021, up from EUR 51.8 billion at the end of 2019. With the NGEU programme gathering pace, EU debt will continue to rise in coming years, mostly because of a large amount of non-repayable resources, equivalent to about EUR 421.1 billion. Nevertheless, DBRS Morningstar considers that the Union remains very well positioned to meet its debt service obligations. EU liabilities corresponding to non-repayable resources will not be matched by corresponding loans but will benefit from likely higher EU member states budgetary contributions and/or the anticipated introduction of new EU own resources going forward. Moreover, 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%, provides significant budgetary headroom to the EU to meet its financial commitments.

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 modest 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 layers of debt-service 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 have demonstrated once again the EU’s ability and willingness to counteract economic shocks. The agreement on a series of measures including 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), paved the way for the one-off NGEU programme consisting of up to EUR 806.9 billion (in current prices) of EU resources to strengthen the recovery and the resilience of the Union.

The decision over the NGEU programme expands previous boundaries related to the EU common debt and central transfers, and reflects stronger cohesion among member states during this crisis. Its success will likely depend on the member states' capacity to implement and deliver on their own national plans. Since June 2021, following member states' ratification of new legislation on own resources, the European Commission (EC), on behalf of the Union, has started to borrow funds under the NGEU programme from financial markets and distribute them to member states through the Recovery and Resilience Facility (RRF) mechanism. This facility makes up to around 90% of the total NGEU and consists of nonrepayable resources up to EUR 338.0 billion and loans up to EUR 385.8 billion. DBRS Morningstar will monitor the evolution of the NGEU programme 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 programmes under the RRF delivers lower results than expected, particularly with regard to reforms and amplifies economic divergences which in turn could weaken cohesion in the Union.

Given its characteristic EU debt issued for nonrepayable resources 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 where EU pays its own debt with the loan redemption payments received from the loan beneficiaries. Future repayments for the nonrepayable funds will be reimbursed by the EU's general budget, largely by new EU own resources and/or higher member state budgetary contributions from the next Multiannual Financial Framework (MFF) in place from 2028. After introducing a non-recyclable plastic packaging waste contribution estimated to amount to around EUR 6 billion in 2021 as well as in 2022, the EC will likely put forward additional proposals for the new EU own resources. These should include a carbon border adjustment mechanism, the revision of the emissions trading system (ETS) scheme and a digital levy. However, in July 2021 after the G20 preliminary agreement on an international corporate tax system which aims to address also the tax challenges arising from the digitalisation of the economy, the EC has decided to put on hold its proposal for a digital levy and to postpone the own resources package until the second half of 2021. Agreements on the new EU own resources are expected to require extensive negotiations among member states.

Support Assessment Remains at AAA and Benefits From the Modest Uplift From Noncore AAA Countries

The EU AAA rating is primarily underpinned by the Support Assessment which reflects the creditworthiness of its core member states (Germany, France (rated AA (high), Stable), Spain (rated 'A', Stable and Italy (rated BBB (high), Negative), their strong commitment to the Union, and the modest uplift from the multiple sources of support, particularly from non-core AAA member states. DBRS Morningstar views the core shareholders ability and commitment to support the Union as strong despite the median weighted rating of the core group of AA (high). 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. DBRS Morningstar believes that the overall political commitment to supporting the institution’s key functions is 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. Although EU member states remain divided on a series of matters including, immigration, foreign policy and fiscal framework, Euroscepticism appears to have receded over the last 18 months. However, DBRS Morningstar will continue to monitor the evolution of a possible anti-EU sentiment which could weaken cohesion in the Union.

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 and predictability, which is expected to remain sound despite the sizeable increase in the debt, mainly resulting from the NGEU. On a seven-year timescale, the MFF benefits from established ceilings for the commitment and payment appropriations for annual budgets during that period. This contributes to budgetary predictability and discipline. While NGEU grants will not follow the typical back-to-back scheme, loans under the NGEU and SURE programmes will be fully repaid by member states and SURE loans repayment also benefits from a guarantee of EU countries totaling EUR 25 billion.

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 borrowings 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 about EUR 197 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 84.5 billion of which EUR 54.1 from core members for 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 (in 2018 prices). 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 de facto 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, Portugal (rated BBB (high), Stable) and Spain will likely be the largest beneficiaries as a result of both the NGEU and SURE programmes and the legacy European Financial Stabilization Mechanism (EFSM) programme. As of end- August 2021, total EU loans outstanding, including the Euratom programme, sharply increased to EUR 166.4 billion compared with EUR 51.9 billion at the end of 2019. So far the large increase has been attributable to the introduction of the SURE program with around EUR 89.6 billion in outstanding loans and the NGEU loans disbursements amounting to EUR 17.9 billion. The rest of the loan book comprises mostly EUR 51.8 billion of loans to Portugal and to Ireland (rated A (high), Positive) under EFSM programme. DBRS Morningstar will continue to assess the evolution and concentration of the loan portfolio as EU debt rises.

First NGEU Issuances at Very Limited Interest Cost Bode Well for the EU Debt Profile

Since June 2021 the EU has started to issue both long-term bonds and EU bills under the NGEU programme at a very low interest cost with maturities that range from 3 months to 10 years, receiving high demand from a diversified investor base. As of mid-September after issuing EUR 1.55 billion under the Macro-Financial Assistance (MFA) programme the EC is expected to borrow EUR 26 billion in long-term bonds and DBRS Morningstar estimates further EUR 20 billion of EU bills under the NGEU programme. From 2022 NGEU debt issuances are expected to hover around EUR 150 billion annually ending in 2026 with front-loading until 2024. EU debt benefits from a comfortable average maturity slightly lower than 12 years which mitigates a rise in interest rates as well as a contained weighted average interest cost of 1.14% which also benefits from the European Central Bank (ECB) expansionary policy. DBRS Morningstar projects interest cost to remain contained despite a less supporting monetary policy in the future, reflecting high demand for safe assets including green bonds, that the EU aims to issue for an amount of EUR 250 billion.

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.

RATING COMMITTEE SUMMARY
The main points discussed during the Rating Committee include EU debt repayments, NGEU programme, new EU own resources, EU loan portfolio, core shareholders’ commitment.

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 https://www.dbrsmorningstar.com/research/374737/global-methodology-for-rating-supranational-institutions (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 NGEU Borrowing presentation: Updates on the European Union’s funding strategy and programme (September 2021), Long-term forecast of future inflows and outflows of the EU Budget (2021-2027) (June 2021), EU Investor presentation (July 2021 and September 2021), Factsheet Funding Plan June-December 2021 (September 2021), Guarantee Fund Balance Sheet (31-07-2021), European Commission, IMF WEO, Bloomberg, 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/384913.

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: March 26, 2021

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