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 DBRS Morningstar’s view that the credit fundamentals of Luxembourg remain solid despite the economic shock brought on by high inflation, particularly for energy prices. The economy’s growth outlook has deteriorated in recent months as the strong increase in global energy prices has adversely impacted consumer and business sentiment and reduced the purchasing power of households. Furthermore, budgetary pressures have increased moderately as the government sought to cushion the adverse impact of high energy prices on households and business through fiscal support measures. These risks, however, are mitigated by Luxembourg’s ample fiscal space for absorbing a temporary increase in budgetary pressures, which results from a comparatively low level of public debt.

The ratings reflect Luxembourg’s very strong public finances. 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 as a business hub. Either of these scenarios could have a significant impact on the economy and on public finances.

RATING RATIONALE

Economy Rebounded Strongly From The COVID-19-Shock But Outlook Is Clouded By Uncertainty And Energy Price Inflation

Luxembourg’s economy recovered from the COVID-19 shock at a comparatively strong pace. Real GDP expanded by 6.9% in 2021 following a contraction of 1.8% in 2020. This rebound was driven by a strong recovery in private consumption and investment and a marked increase in net services exports (particularly financial services). While economic growth dynamics remained strong in the first quarter of 2022 with real GDP growing by 1.2% on a quarter-on-quarter basis, the economy’s short-term outlook has weakened more recently as Russia’s invasion of Ukraine and accompanying energy price inflation have weighed on consumer and business confidence. The annual inflation rate (HICP) amounted to a large 10.4% in June 2022 on the back of high energy price inflation (51.8%). In view of these rising economic headwinds, the European Commission cut its 2022 annual real GDP forecast to 2.6% in July 2022 down from its earlier forecast of 3.9% released in February 2022. The 2023 real GDP growth forecast was revised down to 2.1% from 2.9%. Moreover, a potential prolonged cutoff of Russian gas supplies to EU economies constitutes an important downside risk, albeit to a lesser extent than for some other EU economies which exhibit a greater reliance on Russian gas (e.g. Germany).

Luxembourg’s credit profile continues to be supported by the highly developed nature of its economy and its position as a global financial centre. The country hosts a very large fund industry and numerous international banks and insurers. Financial sector activities accounted for a large 22.9% of nominal GDP in 2021 and constitute, together with business services (13.1%), the backbone of the economy. While ongoing changes in global corporate taxation might reduce the economic activities in certain segments of the financial sector, we expect the overall attractiveness of Luxembourg as a financial hub to remain large due to a highly skilled workforce, a strong legal and regulatory environment, and political stability. Furthermore, 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 adjustment of the ‘Economic Structure and Performance’ building block.

Moderate Increase In Budgetary Pressures Due To Energy-Related Support Measures

After improving markedly over the past year, the government’s budget balance is expected to deteriorate moderately in the ongoing fiscal year. In 2021, the general government budget balance turned into a surplus of 0.9% of GDP from a deficit of 3.4% in 2020 due to strong tax revenue growth and a decline in COVID-19-related budgetary pressures. The size of on-budget COVID-19 support measures decreased to 1.1% of GDP in 2021 from 4.0% of GDP a year earlier. While COVID-19 support measures are likely to decline further in the ongoing fiscal year, the increase in energy prices has raised budgetary pressures. Since early 2022, the government has adopted several on-budget support measures in order to cushion the impact of energy price inflation on households and businesses (e.g. energy tax credits, temporary decrease excise tax fuel, grants to affected businesses). The fiscal cost of these measures is estimated at 1.1% of GDP in 2022. Taking into account higher energy support pressures, the government’s stability programme of April 2022 projects the general government to incur deficits of 0.7% of GDP in 2022 and 0.4% in 2023. Despite this projected moderate weakening, the fiscal metrics of Luxembourg continue to compare favorably with those of most other highly rated sovereigns.

Ratings Continue To Be Underpinned By A Comparatively Low Stock of Public Debt

Government debt has increased over the past two years, but remains on a modest level. General government debt amounted to 24.4% at end 2021, up from 22.3% at end 2019. While the government’s stability programme expects a further modest increase in government debt to 26.2% in 2025, the government debt-to-GDP 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. Therefore, DBRS Morningstar assesses Luxembourg’s fiscal space as very large.

Financial Condition Of Banking Sector Is Sound But Risks Might Emerge From Elevated Housing Prices

The financial condition of the domestic financial sector is sound. Banks are profitable and have comfortable liquidity positions. Moreover, banks benefit from good capital buffers, which are sufficient to absorb some potential weakening of asset quality in the future. According to the IMF, the average capital adequacy ratio of domestically oriented banks amounted to a high 23.2% in September 2021. The COVID-19 shock has not led to a deterioration in asset quality, which partly can be ascribed to extensive government support measures for COVID-hit industries. The NPL ratio of domestically oriented banks stood at a low 1.5% in September 2021 compared to 1.7% in December 2019. Going forward, however, DBRS Morningstar views a potential correction of housing prices in tandem with rising interest rates as a risk factor for banks’ asset quality. Housing prices have increased markedly over the past years, clearly exceeding the increases in rents and incomes. According to the OECD, the price-to-rent and the price-to-income ratios for residential mortgages in Luxembourg rose by a comparatively large 60.4% and 40.4%, respectively between 2015 and 2021. Residential real estate loans account for 37% of total loans. Around 51% of total new mortgage loans extended to households between 2012 and 2021 have fixed the initial interest rate only up until one year, exposing these mortgage borrowers to increases in interest rates. While interest rates have started to increase in recent months, high household wealth provides a safe-guard to the financial system. Households’ aggregate financial net worth stood at 100% of GDP in 2021. The increase in interest rates, together with global financial volatility, also could have an effect on the performance of the large investment fund industry.

The External Position Is Solid And Influenced By The Multinational Sector

Luxembourg’s external position is strong, reflecting persistent current account surpluses and a large net external asset position. The average 4.9% of GDP current account surplus from 2011 to 2021 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) standing at a large 52.8% of GDP at end 2021. Luxembourg’s international investment position is heavily influenced by the activities of multinational companies and the financial sector. It commands over a very high net creditor position in direct investments which, according to data by the central bank, largely relates to special purpose vehicles. Instead, the economy exhibits a very large negative portfolio investment position due to a substantial stock of investment fund shares held by non-residents. 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 adjustment of the ‘Balance of Payments’ building block.

Rating Is Supported By High Institutional Quality And Stable Political Environment

Luxembourg’s rating is underpinned by a high institutional quality and a stable political environment. The country is a strong performer on the World Bank’s Governance Indicators as it is characterised by a high rule of law and low levels of corruption. Furthermore, broad consensus among political parties over sound macroeconomic policies provide the country with policy predictability. 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. The government remains committed to Luxembourg’s strong fiscal framework, including maintaining the public debt ratio below its 30% of GDP ceiling.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

There were no Environmental/ Social/ Governance factor(s) that had a significant or relevant effect on the credit analysis.

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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/400730.

EURO AREA RISK CATEGORY: LOW

Notes:
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 (9 July 2021) https://www.dbrsmorningstar.com/research/381451/global-methodology-for-rating-sovereign-governments. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (17 May 2022) https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

The sources of information used for this rating include Luxembourg Ministry of Finance (2022 Stability Programme), Trésorerie de l'Etat, National Institute of Statistics and Economic Studies of the Grand Duchy of Luxembourg STATEC (Conjuncture Flash July 2022), Banque Centrale du Luxembourg (Statistical tables)), Commission de Surveillance du Secteur Financier (CSSF), Eurostat, European Commission (European Economic Forecast, Summer 2022), Statistical Office of the European Communities, European Central Bank, OECD (Housing Prices), BIS, IMF (2022 Article IV Consultation Report Luxembourg, June 2022), IMF (World Economic Outlook April 2022), IMF (International Financial Statistics), World Bank, 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.

The conditions that lead to the assignment of a Negative or Positive trend are generally 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: https://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/400729.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.
Lead Analyst: Yesenn El-Radhi, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: 16 December 2016
Last Rating Date: 4 February 2022

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