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 notwithstanding the adverse impact of the energy price shock on economic growth and fiscal accounts. Economic growth dynamics have weakened in recent months as the strong increase in global energy prices has weighed on consumer and business sentiment and reduced the purchasing power of households. Furthermore, the government budget balance is expected to deteriorate moderately in 2022 and 2023 on the back of fiscal support measures which seek to cushion the impact of high energy prices on households and businesses. 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 and a large stock of government assets.

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

Economic Growth Dynamics Have Weakened In Recent Months

Similar to other EU countries, economic growth dynamics in Luxembourg have been adversely impacted by the energy price shock which has weighed on business and consumer sentiment. After growing by a strong 0.7% in Q1 2022 on a quarter-on-quarter basis, real GDP contracted by 0.5% in Q2 2022 on the back of lower private consumption and investment spending. On the supply side, a marked decrease in economic activity was observable for industry and construction as these sectors were particularly impacted by rising energy prices and shortages of materials. DBRS Morningstar expects economic growth to remain sluggish during the remainder of this year as sentiment indicators point to a continued deterioration of consumer and business confidence and inflationary pressures have remained high. In October 2022, annual inflation (HICP) stood at a high 8.8%, driven by very large increases in energy prices. Going forward, DBRS Morningstar expects the adverse impact of energy price inflation on domestic demand to be partially mitigated by the government’s recently announced support measures for 2023 (e.g. cap on gas prices, freeze of electricity prices, temporary reduction in VAT). Furthermore, domestic demand is supported by still strong labour markets with the unemployment rate standing at a low 4.5% in September 2022. Taking into account the recent deterioration in economic sentiment and growth dynamics, the IMF revised its annual real GDP growth forecasts for Luxembourg in October to 1.6% for 2022 and to 1.1% for 2023, down from their earlier forecasts of 1.8% and 2.1%, respectively published in April this year.

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 23.6% of nominal GDP in 2021 and constitute, together with business services (9.7%), 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 provides the country with a significant buffer 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

The increase in energy prices has raised budgetary pressures. After registering a surplus of 0.8% of GDP in 2021, the general government budget balance is expected to deteriorate moderately this year and next. The government’s recently released budget 2023 projects the general government to register budget deficits of 0.4% of GDP in 2022 and of 2.2% in 2023. Despite the projected weakening particularly in 2023, DBRS Morningstar notes that the fiscal metrics of Luxembourg continue to compare favourably with those of most other highly rated sovereigns. The projected moderate deterioration in Luxembourg’s fiscal accounts results primarily from the adoption of temporary support measures in March and October 2022 through which the government seeks to cushion the impact of energy price inflation on households and businesses in 2022 and 2023. The total fiscal cost of on-budget energy support measures in both years is estimated at 2.7% of GDP. At the same time, public finances have benefitted from the increase in inflationary pressures in the ongoing year as it boosted nominal tax revenues (particularly household taxes and VAT). During the first nine months of 2022, total tax receipts rose by a large 7.5% on a year-on-year basis.

Ratings Continue To Be Underpinned By A Comparatively Low Stock of Public Debt and Large Government Assets

The government’s comparatively low stock of government debt remains an important credit strength. Although the government’s debt stock is projected to continue to increase moderately over the next years, the government debt-to-GDP ratio remains among the lowest in Europe and below the country’s own ceiling of 30% of GDP. The recently released budget 2023 projects general government debt to increase to a still modest 27.7% at end-2024 from 24.3% at end-2021. Moreover, the government’s repayment capacity is bolstered by large government assets. At end-2021, the general government had a net asset position of 10.8% of GDP (excluding government shareholdings 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 And Rising Interest Rates

DBRS Morningstar assesses the overall financial condition of the economy’s large banking sector as sound. Banks have comfortable liquidity positions and benefit from good capital buffers, which are sufficient to absorb some potential weakening of asset quality in the future. The stock of non-performing loans is currently low with regard both to banks’ total domestic and foreign loan exposures (NPL ratio Q1 2022: 1.0%) as well as to loans to domestic households (1.4%) and non-financial corporations (1.5%). Going forward, DBRS Morningstar views a potential correction of domestic 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 73.2% and 53.6%, respectively between June 2015 and June 2022 compared to average increases of 41.3% and 28.6% for OECD countries. The IMF estimates residential real estate prices in Luxembourg to be overvalued by around 15%. Moreover, the recent increase in interest rates might strain the repayment capacity of mortgage debtors particularly among low-income households. Around 46% of total new mortgage loans which have been extended to households since 2012 have fixed the initial interest rate only up until one year, exposing these mortgage borrowers to increases in interest rates. At the same time, repayment capacity of most households is supported by large household assets. Households’ aggregate financial net worth amounted to 99% of GDP in 2021. In terms of international risk factors, the increase in global interest rates, together with global financial volatility, 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 (NIIP) standing at a large 30.2% 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. The current government coalition which comprises centre-left and centre-right parties (Democratic Party, Luxembourg Socialist Workers’ Party, the Greens) was formed in the aftermath of the October 2013 general elections and was re-elected in 2018. The next general elections are scheduled for October 2023. 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 (17 May 2022).

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/405277.

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
https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments (29 August 2022). In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (17 May 2022) in its consideration of ESG factors.

The sources of information used for this rating include Luxembourg Ministry of Finance (de Budget 2023), 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 October 2022), National Institute of Statistics and Economic Studies of the Grand Duchy of Luxembourg STATEC (Statistical tables), Banque Centrale du Luxembourg (Revue de stabilité financière 2022), Banque Centrale du Luxembourg (Statistical tables), Commission de Surveillance du Secteur Financier (CSSF), European Systemic Risk Board (ESRB Risk Dashboard September 2022), Eurostat, European Commission (European Economic Forecast, Summer 2022), European Commission (Assessment of the Final National Energy and Climate Plan for Luxembourg, 14 October 2020), Statistical Office of the European Communities, European Central Bank (Statistical Data Warehouse), OECD (Housing Prices), BIS, IMF (2022 Article IV Consultation Report Luxembourg, June 2022), IMF (World Economic Outlook October 2022), IMF (International Financial Statistics), World Bank, European Environment Agency (EEA Effort Sharing Decision Dataset, October 2022), 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/405276.

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: Thomas R. Torgerson, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: 16 December 2016
Last Rating Date: 29 July 2022

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