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 is expected to remain strong despite the rising debt and new challenges the Union is facing related to the Russian invasion of Ukraine. So far, EU member states have maintained a united front in imposing sanctions on Russia and DBRS Morningstar does not rule out new initiatives to mitigate the likely uneven impact on member states stemming from the economic consequences of the war. New challenges including new embargoes on Russia, improving the energy independence of the bloc, introducing a strategy for a common defense, and managing the large inflow of Ukrainian refugees will likely once again test cohesion among EU members. Nevertheless, over time the Union has reinforced its capacity to respond to unprecedented shocks to mitigate asymmetric impacts. In DBRS Morningstar's view, the EU is well positioned to implement further extraordinary measures but it may take time to find consensus. New initiatives could reduce economic divergences and strengthen cohesion in the bloc.

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 Next Generation EU (NGEU) programme. Multiple layers of debt-service arrangements that protect creditors remain in place as does 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 is Well Positioned to Repay Its Rising Debt

The EU's debt is rising rapidly but DBRS Morningstar views positively the future increase in revenues along with a higher budgetary headroom to repay the debt. Since October 2020, by issuing at very low costs, the EU started to fund first the Support to Mitigate Unemployment Risks in an Emergency (SURE) programme, which contributed to an increase of the EU debt by around EUR 90 billion and then since June-2021 the one-off NGEU. The latter programme could increase EU debt to almost EUR 1 trillion in coming years from about EUR 249 billion (1.7% of EU27 GNI) in 2021. A large part of the increase will be due to the amount of non-repayable resources, equivalent to about EUR 421.1 billion. The reimbursement of these resources differs from the standard back-to-back repayment scheme where EU debt is matched with the loan beneficiary. EU liabilities corresponding to non-repayable support, instead, will not be matched by corresponding loans but will likely benefit from 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' GNI from 1.2%, provides significant budgetary headroom to the EU to meet its financial commitments.

Russia’s Invasion of Ukraine Adds to Challenges But the EU Member States Commitment to EU Obligations is Expected to Remain Strong

In response to the Russian military invasion of Ukraine, the EU has implemented a series of sanctions which along with higher energy prices, lower confidence and trade disruptions will weigh on the EU's post-pandemic economic recovery. To mitigate the economic consequences of the invasion, so far, the EU authorities have made existing support tools, including the state aid rules, more flexible but DBRS Morningstar does not rule out additional measures in the future.

The decision over the NGEU programme totalling EUR 806.9 billion has expanded previous boundaries related to the EU common debt and central transfers reflecting stronger cohesion among member states. The success of NGEU will depend largely on the member states' capacity to implement and deliver on their own national plans consisting of a combination of investment and reforms. These are linked to the Recovery and Resilience Facility (RRF), which makes up around 90% of the NGEU and consists of EUR 385.8 billion of loans and EUR 338 billion of grants. DBRS Morningstar will monitor the evolution of the NGEU programme and whether or not this will lead to further EU integration among member states.

The EU's 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), Stable), 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 weighted median rating of the core group of AA (high). 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 EU treaties and legislation, the shared joint responsibility for providing the financial resources required to service the EU’s debt. Cohesion among member states has been further reinforced by the extraordinary measures taken to counteract the impact of the pandemic.
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 Multiannual Financial Framework (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 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, there is a political commitment to reimburse the NGEU non repayable resources with new EU own resources. Last year the European Commission (EC) proposed a set of new EU own resources to be effective gradually since 2023. With this proposal the EC aims to introduce new own resources based on a carbon border adjustment mechanism, on a revised EU Emissions Trading System (ETS) and on a share of the residual profits of the largest and most profitable multinational enterprises that are allocated to member states following the agreement by the OECD/G20. This initiative is expected to generate on average up to EUR 17.0 billion (in constant 2018 prices) annually over the period 2026-2030 to finance the Social Climate fund as well for the repayment of the non-repayable component of the NGEU. Moreover, the EC intends to propose an additional basket of EU own resources which could consist of a financial transaction tax and an own resources linked to the corporate sector by the end of 2023. However, agreements on both baskets of new EU own resources might require extensive negotiations among member states.

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 the EU’s available resources. These can be prioritised for debt service whether or not they have been committed elsewhere. 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 214 billion in 2022) 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 91.8 billion of which EUR 58.5 from core members for 2022). 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). 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), Positive) and Spain will likely be the largest beneficiaries as a result of both the NGEU and SURE programmes and the legacy European Financial Stabilisation Mechanism (EFSM) programme. As of mid-March 2022, total EU loans outstanding, including the Euratom programme, sharply increased to EUR 167.1 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 19.9 billion. The rest of the loan book mostly comprises cumulatively EUR 49.0 billion of loans to Portugal and to Ireland (rated AA (low, Stable) under the EFSM programme. DBRS Morningstar will continue to assess the evolution and concentration of the loan portfolio as EU debt rises.

EU Debt Issuances at Very Low Interest Costs Bode Well for the EU Debt Profile

Since October 2020, the EU has started to issue debt to fund SURE and since June 2021 also both long-term bonds and EU bills under the NGEU programme at a very low interest cost with maturities that range from three months to 10 years, receiving high demand from a diversified investor base. The latest EC funding plan foresees for the first six months of 2022 total bond issuances of EUR 5.5 billion under the EFSM, SURE, and the Macro-Financial Assistance (MFA) programme and EUR 50 billion of long-term bonds under the NGEU. Annually NGEU debt issuances are expected to hover around EUR 150 billion ending in 2026. Debt maturities under NGEU are expected to be spread over a 30-year time horizon which would help the EU to benefit from a comfortable average maturity, at the moment slightly lower than 11 years. This mitigates against a rapid rise in interest rates. So far, financing cost has been very contained and benefited also from the European Central Bank (ECB) still accommodative policy. The weighted average cost for NGEU funding amounted to 0.14% in 2021 across maturities from 5-30 years. DBRS Morningstar projects interest costs to remain moderate despite a less supportive monetary policy going forward, reflecting also 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, EU measures in response to the Russian invasion of Ukraine.

Notes:
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/392578/global-methodology-for-rating-supranational-institutions February 17, 2022). 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 NextGenerationEU funding plan January-June 2022 (December 2021), Semi-annual report on the execution of the NextGenerationEU funding operations pursuant to Article 12 of Commission Implementing Decision C(2021)2502 (February 2022), EU Investor presentation (March 2022), Guarantee Fund Balance Sheet (31-07-2021), The next generation of own resources for the EU Budget (December 2021), Remarks by Commissioner Hahn at the press conference on new own resources (December 2021), Long-term forecast of future inflows and outflows of the EU budget (2021-2027) (June 2021), 2022 General EU budget, European Commission, AMECO, 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/394252,

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 24, 2021

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