DBRS Morningstar Confirms the European Stability Mechanism at AAA, Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the European Stability Mechanism’s (ESM) Long-Term Issuer Rating at AAA and Short-Term Issuer Rating at R-1 (high). The trend on both ratings is Stable.

KEY RATING CONSIDERATIONS
DBRS Morningstar rates the ESM on the basis of its Support Assessment and its Intrinsic Assessment. The Support Assessment is the primary driver of the ESM’s ratings and is at a level equivalent to AAA reflecting the overall credit quality of the ESM’s core shareholders, their collective commitment to support the institution as well as the additional diversification benefits stemming from AAA governments outside the core group. The ESM’s Intrinsic Assessment, also at a level of AAA, is underpinned by (1) the institution’s high capitalisation; (2) its strong and effective liquidity management; and (3) its preferred creditor status.

RATING DRIVERS
The rating could be downgraded if one or a combination of the following occur: (1) there is a marked deterioration in the 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 Monetary Union; or (2) there is a substantial weakening of the ESM's Intrinsic Assessment.

RATING RATIONALE

Economic Headwinds For Euro Area Economies Have Increased Over The Past Few Months

The increase in energy prices and broadening inflationary pressures have weakened households' purchasing power and raised input costs particularly for energy-intensive manufacturing industries. Furthermore, the tightening of monetary policy by the European Central Bank (ECB) has been accompanied by a rising divergence in financing costs for Euro area governments, the extent of which, however, remains so far clearly below the levels seen during the crisis years 2011 and 2012. DBRS Morningstar will monitor potential divergences in economic, fiscal and debt positions across European countries, particularly if they were to lead to lower cohesion. Perceptions of greater divergences may give rise to further Euroscepticism and could bring new challenges to additional European integration.

ESM Is An Essential Tool of Euro Area Policymakers for Fostering Cohesion

While energy price inflation has raised economic headwinds for Euro area economies, DBRS Morningstar expects the commitment of European policymakers towards the Monetary Union and economic cohesion in EU economies to remain very high. This commitment was exemplified in the past by substantial support measures during the Euro area sovereign debt crisis about a decade ago and the COVID-19 pandemic. In November 2020, EU member states agreed on the Next Generation EU (NGEU) programme, providing grants and loans to European member states of up to EUR 750 billion (in 2018 prices). The ESM was part of the early European response package, offering Pandemic Crisis Support to euro member states in the form of a precautionary credit line (ECCL, Enhanced Conditions Credit Line), available for domestic financing of direct and indirect healthcare, cure and prevention-related costs related to COVID-19 of up to 2% of a country's gross domestic product (GDP). This backstop, which had been available until the end of 2022 for all 19 euro area member states was scaled at a maximum of EUR 240 billion. While the requirements attached to the provision of these loans had been discussed and agreed beforehand, and member states were able to request funds since May 2020, no Euro area country tapped into this credit line.

DBRS Morningstar also considers that the proposed widening of the ESM’s mission announced as part of a package of reforms to strengthen the Monetary Union would strengthen its policy mandate and support DBRS Morningstar’s assessment of the shareholders’ commitment to the institution. While the ESM reform has been formally agreed by the Eurogroup on 30 November 2020, only Italy (BBB (high), Stable) has so far not completed the ratification of the revised ESM Treaty. The ESM's proposed new missions include (1) the provision of a backstop to the Single Resolution Fund (SRF) of up to EUR 68 billion in the form of a credit line; (2) a reinforced role in designing and monitoring future country programmes together with the European Commission; (3) a greater role for the ESM outside the programmes, providing macroeconomic and financial expertise; (4) the improvement of the ESM precautionary credit lines; and (5) the commitment in the ESM Treaty by member states to include single-limb collective action clauses in future sovereign bonds issuances (from the first day of the second month following the entry into force of the revised ESM Treaty).

The Support Assessment Reflects the ESM’s Core Shareholders’ Creditworthiness and Their Commitment to the Institution

DBRS Morningstar defines the ESM core shareholder group as the Federal Republic of Germany (AAA, Stable), the Republic of France (AA (high), Stable), the Republic of Italy (BBB (high), Stable), and the Kingdom of Spain (A, Stable). These four shareholders cumulatively account for 77% of the total capital contribution key. The accession of Croatia to the ESM over the course of 2023 will impact the existing shareholder structure only very modestly as Croatia's eventual ESM contribution key will amount only to 0.52%. The weighted median shareholder rating of the core shareholder group, which is the primary driver of the Support Assessment, currently stands at AA (high), in line with France's rating. Despite the AA (high) weighted median core shareholders' rating, DBRS Morningstar considers that the ESM's Support Assessment remains at AAA. This reflects the strong credibility of the commitment of Euro area member states towards the institution combined with the additional diversification benefits stemming from AAA governments outside the core guarantor group.

The ESM’s Intrinsic Assessment Remains Driven by its Very Strong Capitalisation

The AAA Intrinsic Assessment of the ESM primarily reflects the entity’s capital structure, which consisted of EUR 80.55 billion in paid-in capital at year-end 2021, serving as a strong backing for the ESM’s bonds and other debt securities, and another EUR 624.25 billion in committed callable capital. The paid-in capital accounts for a very large 93% of the ESM’s current loan book of EUR 86.2 billion and 16% of its total lending capacity of EUR 500 billion, of which EUR 413.8 billion is available for new lending. The ESM loan portfolio is characterised by a high degree of concentration in the Hellenic Republic (BB (high), Stable), representing 69.4% of the total, Spain with 23.3% and Cyprus (BBB, Stable) with 7.3%. In DBRS Morningstar’s view, the strict existing programme conditionality and review process, the ESM’s preferred creditor status, its strong liquidity management and high capital levels, should continue to mitigate the related credit and concentration risks.

The ESM’s Strong Liquidity Management and its Preferred Creditor Status Also Support its Creditworthiness

The potential future extension of ESM lending is unlikely to challenge that assessment as long as other safeguards remain in place. DBRS Morningstar views for instance positively the ESM’s conservative liquidity management practices. Operational guidelines require liquid assets to cover the ESM obligations coming due in the next 12 months. These assets reflect the ESM paid-in capital, which cannot be lent out as part of a financial assistance programme under any of the ESM’s existing instruments. Instead, these funds are invested in highly rated liquid assets, and act as a capital and liquidity cushion. The ESM is moreover building a responsible investment framework to include environmental, social and governance (ESG) criteria within its investment processes.

Finally, DBRS Morningstar considers that the ESM's preferred creditor status supports the institution’s Intrinsic Assessment by providing additional protection compared to unsecured creditors. DBRS Morningstar, nevertheless, notes that the financial assistance programme for Spain was negotiated by the European Financial Stability Facility (EFSF, AAA Stable) prior to being transferred to the ESM and, therefore, does not benefit from the additional seniority provided to the funding of other programmes.

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.

RATING COMMITTEE SUMMARY

The main points discussed during the Rating Committee include the impact of energy price inflation on Euro area economies and its impact on the ESM’s shareholders cohesion and commitment to the institution, the risk profile and capitalisation of the ESM and their potential evolution in the future.

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 (17 February 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 the ESM 2021 annual report, the EFSF and ESM Investor Presentations (July 2022, January 2023), the EFSF and ESM carbon footprint report, the European Commission’s post-programme surveillance report on Greece (November 2022), the European Commission Autumn 2022 forecasts. 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: NO
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/408622.

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 Global Sovereign Ratings
Initial Rating Date: July 27, 2012
Last Rating Date: July 22, 2022

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