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 its 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 and ability to support the Union is expected to remain strong, despite the rising debt and the new challenges the EU is facing related to Russia's invasion of Ukraine. The projected material increase in EU debt to almost EUR 1 trillion, mainly as a result of the Next Generation EU (NGEU) instrument, will likely generate high debt service costs in the future. Nevertheless, the increase in the budgetary headroom, the obligation of member states to finance the agreed expenditure levels, the future introduction of new EU own resources and repayments from loan beneficiaries should comfortably enable the Union to repay its debt. Frictions between the European Commission (EC) and Hungary and Poland, which have intensified over recent years will not derail cohesiveness and commitment to the EU's obligations.

DBRS Morningstar rates the EU primarily based on its Support Assessment of AAA. This is underpinned by the creditworthiness of the Union's core member states, their strong commitment to the EU, and the uplift from multiple sources of support, particularly from non-core AAA-rated member states. At the same time, the EU benefits from conservative budgetary management. Multiple layers of debt-service arrangements that protect creditors remain in place, despite the significant rise in debt following the introduction of the NGEU programme. The Union has a 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 the creditworthiness of a single core shareholder, particularly if it reflects a material weakening in 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

To fund the NGEU programme totalling EUR 806.9 billion the EU's debt is rising rapidly, but DBRS Morningstar views positively the higher budgetary headroom along with the member states’ commitment to introducing new own resources to repay debt. EU debt is expected to increase to almost EUR 1 trillion up to 2026 from about EUR 347 billion (2.2% of EU27 GNI) in 2022. Total NGEU debt will finance both grants and other non-repayable resources up to EUR 421.1 billion and potential loans up to EUR 385.8 billion. These loans will be repaid by loan beneficiaries. Moreover, the increase in the EU's own-resource ceiling to 2.0% (of which 0.6 percentage points on a temporary basis until 2058, for NGEU) from 1.2% of EU GNI, provides the EU with significant budgetary headroom to meet its annual financial commitments.

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

The current challenges stemming from the conflict in Ukraine, including sanctions and the ongoing energy shock, have been another test of cohesion among member states. The related economic headwinds could result in widening economic divergences among member states which could lead to lower cohesion if not addressed collectively. Despite some delays and some divisions among member states, the EU agreed on several measures. These include mainly a strategy to reduce energy dependence on Russia, the introduction of a price cap, and additional resources, albeit moderate, to mitigate the impact of the shock. In addition, member states have also agreed to provide additional funding to Ukraine. Although the uncertainty over the evolution of both the conflict and the energy crisis remains high, member states’ cohesion is expected to remain strong and not undermine support for the Union.

Future integration and cohesiveness in the EU will likely be dependent on the success of the NGEU programme. This instrument which mostly includes the Recovery and Resilience Facility (RRF) consisting of EUR 385.8 billion of loans and EUR 338 billion of grants has been gradually gaining impetus. Nevertheless, its implementation appears slow with around 8% of total milestones and targets having been fulfilled so far. The NGEU's success will depend largely on the member states' capacity to implement and deliver on their own national plans consisting of investment and reforms. DBRS Morningstar expects an acceleration in execution going forward and 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 its 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 uplift from multiple sources of support, particularly from non-core AAA-rated member states. DBRS Morningstar views the core shareholders' ability and commitment to support the Union as strong, despite the weighted median rating of AA (high) for the core group. However, the EU enjoys the presence of a set of other AAA-rated member states, whose contributions DBRS Morningstar considers to be 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 Union's budget and, as established by EU treaties and legislation, the shared joint responsibility for providing the financial resources required to service the EU’s debt.

Sound Budgetary Management and De Facto Preferred Creditor Status Support the Ratings

The ratings are further supported by the EU’s conservative budgetary management and predictability, which should remain sound despite the sizeable increase in the debt. On a seven-year timescale, the Multiannual Financial Framework (MFF) benefits from established ceilings for commitment and payment appropriations for annual budgets during that period. This contributes to budgetary predictability and discipline.

While member states will fully repay loans under the NGEU and SURE programmes, there is a political commitment to reimburse the NGEU nonrepayable resources with new EU own resources. In December 2022, co-legislators reached a political agreement on the EU ETS Directive and the on a carbon border adjustment mechanism (CBAM) regulation. These two measures along with the share of the residual profits from the largest and most profitable multinational enterprises are expected to generate an average of up to EUR 17.0 billion (in constant 2018 prices) annually over the 2026–30 period once a final agreement on new own resources has been reached. These resources will finance the Social Climate Fund and help with repaying the nonrepayable component of the NGEU. Moreover, the EC intends to propose an additional basket of EU own resources that could consist of a financial transaction tax and an own resource linked to the corporate sector by the end of 2023. A final agreement on overall EU own resources might require time and 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 Union’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 GNI (estimated at about EUR 234 billion in 2023) 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 100 billion, of which EUR 63 billion stems from core members for 2023). This appears to be comfortable considering that, under this scheme, principal annual debt repayments will not exceed 7.5% or EUR 29.25 billion of the EUR 390 billion in 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 and Weakening but Will be Less Geographically Concentrated

The EU’s credit risk portfolio is weakening as a result of the increased exposure to Ukraine and Italy but it will be more diversified than in the past. However, Italy, Spain, Portugal (rated A (low), Stable) and Ireland (rated AA (low), Stable) will likely be the largest beneficiaries of both the NGEU and the SURE programmes and the legacy European Financial Stabilisation Mechanism (EFSM) programme. As of December 2022, total EU loans outstanding, including the Euratom programme, sharply increased to around EUR 205 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, amounting to EUR 98.4 billion in outstanding loans, and the NGEU loan disbursements, amounting to EUR 45.2 billion. The rest of the loan book mostly comprises EUR 46.3 billion in loans to Portugal and to Ireland under the EFSM programme. In response to the invasion of Ukraine, the EU aims also to provide additional funding under the MFA+ programme for Ukraine totalling EUR 18 billion corresponding to half of the Ukraine funding needs for 2023. DBRS Morningstar will continue to assess its evolution, and the concentration risk as the EU debt rises.

Despite the Monetary Tightening, EU Continues to Issue at Moderate Costs Which Bode Well for the EU Debt Profile

The EC has been increasing its borrowings markedly since 2020 and it is expected to continue to issue bonds at moderate, although rising costs. For the main programme, NGEU, the average cost of the funding pool of long-term borrowing increased rapidly to an estimated 2.6% over the period of the last six month of 2022 from 1.24% over the same period in the first half of the year but mainly reflected the tightening in the monetary policy. Rising rates are not undermining the strong demand for EU bonds as well as the diversified base with a good representation of different types of investors. This is also supported by the high volume of NGEU green bonds the EC plans to issue, amounting to up to EUR 250 billion. Moreover, overall EU debt benefits from a comfortable average maturity estimated at slightly higher than 11 years, which mitigates the risk of refinancing. DBRS Morningstar views EU debt as enjoying a high degree of predictability with expected annual NGEU borrowing needs of around EUR 150 billion on average until 2026. The EC has recently decided to extend the diversified funding strategy used to finance the NGEU programme to the MFA+ support to Ukraine and future programmes. In DBRS Morningstar's view, this would increase issuance flexibility and benefit from a more robust risk and governance framework.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Governance (G) Factors
Institutional Strength, Governance and Transparency (G) factor affects significantly the ratings assigned. 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.

There were no Environmental and Social factors 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).

RATING COMMITTEE SUMMARY
The main points discussed during the Rating Committee include EU debt repayments, NGEU programme, new EU own resources, core shareholders’ commitment, EU funding approach, EU measures adopted in relation to Russia’s invasion of Ukraine.

Notes:

All figures are in Euro unless otherwise noted.

The principal methodology is the Global Methodology for Rating Supranational Institutions https://www.dbrsmorningstar.com/research/409963/global-methodology-for-rating-supranational-institutions (16 February 2023). 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).

The sources of information used for this rating include NextGenerationEU funding plan January-June2023 (December 2022), Semi-annual report on the execution of the NextGenerationEU funding operations pursuant to Article 12 of Commission Implementing Decision C(2021)2502 (February 2023), EU Investor presentation (February 2023), Article 41(5) report (June 2022), Long-term forecast of future inflows and outflows of the EU budget (2021-2027) (June 2021), Long-term forecast of future inflows and outflows of the EU budget (2023-2027) (June 2022), 2022 EU Budget, 2023 EU Budget, European Commission, AMECO, IMF WEO, 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: YES
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/410532.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Carlo Capuano, Senior 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 23, 2022

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