Morningstar DBRS Confirms the European Union at AAA, Stable Trend

DBRS Ratings GmbH (Morningstar DBRS) confirmed the European Union’s (EU or the Union) Long-Term – Issuer Rating at AAA. At the same time, Morningstar DBRS confirmed the European Union’s Short-Term – Issuer Rating at R-1 (high). The trend on all ratings is Stable.

KEY CREDIT RATING CONSIDERATIONS
The Stable trend reflects Morningstar DBRS’ view that member states' commitment and ability to support the Union is expected to remain strong, despite rising debt and geopolitical risks. The projected material increase in EU debt to a maximum of almost EUR 1 trillion, mainly as a result of the Next Generation EU (NGEU) temporary 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 system of EU own resources and repayments from loan beneficiaries, should comfortably enable the Union to repay its debt.

Morningstar DBRS 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. Moreover, 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 and the Union has a de facto preferred creditor status.

CREDIT RATING DRIVERS
The EU’s credit 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).

CREDIT RATING RATIONALE

The EU is Well Positioned to Repay Its Rising Debt

To fund the NGEU programme the EU's debt is rising rapidly, but Morningstar DBRS views positively the higher budgetary headroom along with the member states’ commitment to introduce new EU own resources to repay debt. EU debt is expected to increase to a maximum of almost EUR 1 trillion up to 2026 from about EUR 458 billion (2.7% of EU27 GNI) in 2023. Total NGEU debt will finance both grants and other NGEU non-repayable resources up to EUR 421.1 billion and Recovery and Resilience Facility (RRF) loans amounting to EUR 292.6 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.

EU Member States’ Commitment to EU Obligations is Expected to Remain Strong and To Face Challenges With United Response

The current challenges stemming from the conflict in Ukraine, including sanctions and the ongoing energy transition, and the recent increase in refugee numbers 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 and extension 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 the conflict remains high, member states’ cohesion is expected to remain strong and not undermine support for the Union.

More recently, the geopolitical tensions in the Middle East could also be another test of the Union, especially if there is an escalation to a broader regional conflict. Despite diverging views from a few member states, the EU reaction is being also coordinated as a union. The EU track record of united response, once more illustrated by the revision of the EU budget for 2021-2027 in February of 2024, reassured of the EU’s ability to deliver its objectives and fund new priorities. The EU budget is currently adjusted for more recent challenges and economic obstacles, although the unanimity requirement for this modification caused the Union to approve it with a moderate delay mainly due to individual interests that caused longer negotiations.

Likewise, the EU reached a common agreement on a new economic governance framework and also on a pact on migration and asylum ahead of the upcoming June 2024 EU elections. The importance of these agreements will play a role in the elections along with the obstacles and discussions that member states are maintaining around the next challenges (such as EU enlargement, the call to increase defense budgets, the continuation of climate friendly policies or to diminish its economic reliance on third countries) and all at a time where the EU diplomacy role seems to be crucial for the geopolitical landscape. Morningstar DBRS does not expect a strong change in policy making at the EU after the elections, nor a damaged cohesion among members, although the order of priorities could be slightly modified.

Future integration and cohesiveness in the EU will likely also be dependent on the success of the NGEU programme. This instrument which mostly includes the RRF has been gradually gaining impetus. Nevertheless, its implementation appears slow with around 18% 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 investments and reforms. Morningstar DBRS 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 credit rating is primarily underpinned by its Support Assessment, which reflects the creditworthiness of its core member states - Germany (rated AAA, Stable), France (rated AA (high), Stable), Spain (rated 'A', Stable, and Italy (rated BBB (high), Stable), their very strong commitment to the Union, and the uplift from multiple sources of support, particularly from non-core AAA-rated member states. Morningstar DBRS views the core shareholders' ability and commitment to support the Union as strong, despite the weighted median credit 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 Morningstar DBRS considers to be sufficient to maintain the EU’s Support Assessment at AAA. Morningstar DBRS 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.

A potential modest weakening of the weighted median rating of the core shareholders is not expected to undermine the credit profile of the Union, provided that cohesion among core shareholders or their political commitment does not weaken materially. Moreover a set of AAA countries outside the core group could still provide sufficient additional support to the Union. In Morningstar DBRS' view, multiple shocks, including Russia’s invasion of Ukraine and the subsequent energy crisis has demonstrated strong political commitment and cohesion in the Union. The mandate of the EU has been further reinforced by NGEU resources to improve the resilience of the member states facing the pandemic shock. This, to some extent, strengthens the incentive to provide support to the Union. Moreover, the multiple source of support benefits particularly from non-core AAA rated countries that, if called on for up to 2% of their GNI, are likely to provide a sizable amount of resources. Morningstar DBRS estimates this equivalent to EUR 52 billion in 2024.

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

The credit 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 support with new EU own resources. However, legally the EU budget will always honor its obligations unconditional on the introduction of new EU own resources. In December 2021, the EC put forward a set of new EU own resources. including the Emissions Trading System (ETS) own resource, a Carbon border adjustment mechanism (CBAM) own resource, and additional new own resource based on the residual profits of very large multinational corporations reallocated to member states. In June 2023, the EC completed its proposal for these new EU own resources including the new temporary statistical based own resource that will be calculated as 0.5% of the gross operating surplus statistics for financial and non-financial corporations of each Member State, as recorded by Eurostat under the European system of accounts (on the basis of the national accounts statistics). The new EU own resources combined are expected to generate on average over 2025-2027, about EUR 23 billion per year (in constant 2018 prices). From 2028 the scope of ETS own resource will be broadened to include the newly established ETS2 and all the new EU own resources combined are expected to raise revenues of EUR 36.5 billion on average per year (in constant 2018 prices) over 2028-2030. These resources will finance the Social Climate Fund and help with repaying the nonrepayable component of the NGEU once the proposal passes through the European Parliament and the European Council.

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 248 billion in 2024) 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 106 billion, of which EUR 67 billion stems from core members for 2024). 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, Morningstar DBRS 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. However, it is partly mitigated by a more diversified portfolio than in the past and some counterparties' credit quality is improving, as evidenced by last year's upgrade of Portugal (rated A, Stable) or the recent trend change on Republic of Ireland (rated AA (low), Positive). Portugal, Italy, Spain and Ireland 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 end February 2024, total EU loans outstanding, including the Euratom programme, sharply increased to EUR 255.0 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 progressive NGEU RRF loan disbursements, amounting to EUR 80.2 billion. The rest of the loan book mostly comprises EUR 42.8 billion in loans to Portugal and to Ireland under the EFSM programme. In response to the invasion of Ukraine, the EU has increased the amount of loans to Ukraine totalling EUR 18 billion through the MFA+ programme, and EUR 11.6 billion under the MFA programme, and committed for additional EUR 50 billion until 2027, of which EUR 33 billion as loans.

The EC has been increasing its borrowings markedly since 2020 and it is expected to continue to issue a sizeable amount of bonds. The average cost of the funding pool of long-term borrowing increased rapidly to an estimated 3.6% in the second half of 2023 from 3.2% over the previous semester, mainly reflecting the tightening in monetary policy. The increasing cost of debt led the EC to update the financing cost of funding within the 2021-2027 MFF review, and a resolution to increase funds to cover these unforeseen interest costs and inflation by EUR 20.8 billion. Rising rates are not undermining the strong demand for EU bonds nor 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 30% of total issuance for NGEU and so far EUR 56 billion is issued. Moreover, overall EU debt benefits from a comfortable average maturity estimated at slightly higher than 11 years, which mitigates the risk of refinancing. Morningstar DBRS 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 decided to extend the diversified funding strategy used to finance the NGEU programme to the MFA+ support to Ukraine and future programmes. In Morningstar DBRS' view, this would increase issuance flexibility and benefit from a more robust risk and governance framework.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
General Considerations

ESG Considerations had a significant effect on the credit analysis.

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 or Social factors that had a significant or relevant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (23 January, 2024) at, https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

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 members cohesion, EU funding approach, EU elections.

Notes:
All figures are in Euros unless otherwise noted.

The principal methodology is the Global Methodology for Rating Supranational Institutions (16 February 2024) https://dbrs.morningstar.com/research/428245/global-methodology-for-rating-supranational-institutions. In addition, Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings, https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings, in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

The sources of information used for this credit rating include EU budget funding plan January-June 2024 (December 2023), EU Investor presentation (April 2024), Half-yearly report on implementation of borrowing, debt management and related lending operations pursuant to Article 12 of Commission Implementing Decision C(2022)9700 (February 2024), Press Release – Commission welcomes agreement on EU Annual Budget 2024 (November 2023), Press Release – EU leaders discuss support for Ukraine, enlargement, and the situation in the Middle East during European Council meeting (March 2024), Press Release – Commission welcomes political agreement on a new economic governance framework fit for the future (February 2024), Press Release – EU budget: Commission puts forward an adjusted package for the next generation of own resources (June 2023), Press Release – EU budget: Commission proposes to reinforce long-term EU budget to face most urgent challenges (June 2023), Factsheet EU Solidarity with Ukraine – European Commission (November 2023), European Parliament In-Depth Analysis – What role for the European semester in the recovery plan? (October 2020), Long-term forecast of future inflows and outflows of the EU budget (2021-2027) (June 2021), European Parliamentary Research Service – Revision of the EU’s long-term budget for 2021 to 2027 (September 2023), Long-term forecast of future inflows and outflows of the EU budget (2024-2027) (June 2023), 2021 EU Budget, 2022 EU Budget, 2023 EU Budget, 2024 EU Budget, European Commission, AMECO, IMF WEO, Haver Analytics. Morningstar DBRS considers the information available to it for the purposes of providing this credit 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

Morningstar DBRS does not audit the information it receives in connection with the credit 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. Morningstar DBRS’ outlooks and credit ratings are under regular surveillance.

For further information on Morningstar DBRS historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication. For further information on Morningstar DBRS historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at: https://dbrs.morningstar.com/research/431679.

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

Lead Analyst: Jorge Espinosa, Assistant Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Global Sovereign Ratings
Initial Rating Date: July 11, 2014
Last Rating Date: November 10, 2023

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