Morningstar DBRS Confirms Grand Duchy of Luxembourg at AAA, Stable Trend

DBRS Ratings GmbH (Morningstar DBRS) confirmed the Grand Duchy of Luxembourg's Long-Term Foreign and Local Currency - Issuer Ratings at AAA. At the same time, Morningstar DBRS 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 CREDIT RATING CONSIDERATIONS

The confirmation of the Stable trend reflects Morningstar DBRS' view that the credit fundamentals of Luxembourg remain solid, notwithstanding a moderate increase in budgetary pressures. Over the past year, the general government budget deficit widened to 1.3% of GDP from 0.3% in 2022, driven by a step-up in energy support measures. Looking ahead, fiscal balances are likely to continue to post moderate deficits given the extension of most energy support measures until the end of 2024 and as recent tax measures are likely to weigh on government revenues. In Morningstar DBRS' view, however, Luxembourg has ample fiscal space to accommodate potential moderate budgetary deficits over the next few years without putting pressure on the AAA ratings. The share of public debt at GDP is low and the government's repayment capacity is bolstered by a large stock of government assets. Furthermore, while real GDP contracted last year, it is forecast to rebound in 2024 and 2025, aided by a recovery in service exports and robust private consumption.

The credit ratings reflect Luxembourg's very strong public finances. The credit 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.

CREDIT RATING DRIVERS

Given Luxembourg's strong fundamentals, Morningstar DBRS sees a downgrade of the credit 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, that could have a significant impact on the economy and on public finances. A downgrade could also come from material damage to Luxembourg's attractiveness as a business hub that could have a similar impact.

CREDIT RATING RATIONALE

General Government Budget Balance Is Forecast to Post Moderate Budget Deficits Over the Next Years

Budgetary pressures increased over the past year. The general government budget deficit widened to an, albeit still moderate, 1.3% of GDP in 2023 from 0.3% in 2022 as the government stepped up energy support measures to around 1.6% of GDP, up from 0.7% a year earlier. In addition, the indexation of social benefits and public wages to inflation drove up nominal expenditure levels. Total general government expenditure rose by 12.2% in 2023, exceeding the 10.1% increase in government revenues which mainly resulted from higher income tax revenues and social contributions. Looking ahead, the general government budget is likely to continue to post moderate deficits as most energy support measures have been extended until end 2024.

Furthermore, the new government adopted different tax measures which aim at strengthening households' purchasing power and, in particular, demand for housing. This includes a higher-than-previously-planned adjustment of personal income tax brackets to inflation in 2024, an increase in the tax credit for owner-occupied real estate purchases and higher tax deductibility limits for mortgage loan interest payments. Taking into account the new government's fiscal measures, the IMF forecasts the general government budget deficit to widen to 2.1% of GDP in 2024 before narrowing to 1.5% in 2025. In contrast, the government's Stability Program 2024 does not project a temporary deterioration of fiscal balances and forecasts the general government budget deficit at 1.2% of GDP both in 2024 and 2025.

Credit Ratings Continue to Be Underpinned by Low Public Debt and Large Government Assets

Although the government's debt stock is likely to increase moderately over the next years, Luxembourg's debt-to-GDP ratio is projected to remain among the lowest in Europe. General government gross debt amounted to just 25.7% of GDP in 2023. The IMF forecasts government debt to increase to a still low 29.5% of GDP in 2026. Moreover, the government's repayment capacity is bolstered by large government assets. At end-2023, the general government had a net asset position of 6.1% of GDP (excluding government shareholdings in several commercial and non-commercial companies). Therefore, Morningstar DBRS assesses Luxembourg's fiscal space as very large.

Economic Activity Weakened in 2023 But is Forecast to Rebound This Year

Real GDP contracted by 1.1% in 2023, weighed down by lower external demand for services and, to a lesser extent, weaker investment activity. These two factors more than offset the positive growth contribution of private consumption which continued to expand at a robust pace. This resilience in private consumption can be ascribed to wage indexation and several direct and indirect government support measures which bolstered households' purchasing power such as a temporary reduction of selected VAT rates, the introduction of gas and electricity price caps and the granting of free access to certain services (e.g. public transportation). On the supply side, the weakening in growth dynamics was particularly pronounced in the financial sector. In real terms, gross value added in the financial sector declined by a large 7.0%. Looking ahead, the IMF forecasts real GDP to rebound by 1.3% in 2024 and by 2.9% in 2025 on the back of a recovery in service exports. Furthermore, households' purchasing power is likely to be bolstered by the extension of most support measures until the end of 2024 and by recent tax measures.

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 23.5% of total nominal gross value added in 2023 and constitute, together with business services (12.5%), the backbone of the economy. While ongoing changes in global corporate taxation could affect the operations of multinational companies, Morningstar DBRS takes the view that the overall attractiveness of Luxembourg as a financial hub is likely 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 Morningstar DBRS' positive adjustment of the `Economic Structure and Performance' building block assessment.

Change in Government Is Unlikely to Alter Overall Direction of Government Policy

The general elections in Luxembourg in October 2023 have led to a new government. After governing since 2013, the three-party "Gambia" coalition (Luxembourg Socialist Workers' Party, the Greens, Democratic Party) failed to secure a parliamentary majority in the general elections. Instead, the centre-right Christian Social People's Party formed a government coalition with the Democratic Party. Despite this change in government, Morningstar DBRS takes the view that overall policy continuity will remain high over the next years. There is a broad consensus among the main political parties on key policy topics, including fiscal, macroeconomic and foreign affairs. The credit ratings are also underpinned by a high institutional quality. 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.

Financial Condition of Banking Sector Is Good but Asset Quality Risks are Tilted to the Downside

Morningstar DBRS assesses the overall financial condition of the economy's large banking sector as favourable. Banks have comfortable liquidity positions and benefit from good capital buffers. Furthermore, the current stock of non-performing loans is low. Looking ahead, however, pockets of vulnerability for asset quality might arise from a comparatively large decline in domestic housing prices in tandem with high interest rates. After increasing markedly over past few years, housing prices in Luxembourg have decreased more strongly over the past year than in most other Euro area countries. Between their peak in Q3 2022 and Q4 2023, house prices in Luxembourg declined by a total of 15.7% compared to a decrease of just 2.9% for the entire Euro area. The price correction was particularly pronounced for existing houses which registered an average price decline of 18.4%.

Furthermore, the recent increase in interest rates might strain the repayment capacity of some households. The average interest rate on households' outstanding loans rose to 4.1% in February 2024, up from 2.2% two years earlier. While the repayment capacity of most households is supported by large household assets and a strong labour market as well as wage indexation, Morningstar DBRS takes a conservative approach to the financial risks faced by the banking sector and applies a negative qualitative adjustment to the `Monetary Policy and Financial Stability' building block assessment. In terms of the large investment fund industry, Morningstar DBRS notes that, while the industry has registered net redemptions of fund shares over the past few months, the scale of these outflows was modest and is, therefore, unlikely to have raised liquidity pressures.

The External Position Is Solid and Influenced by the Multinational Sector

Luxembourg's external position benefits from persistent current account surpluses on the back of large net exports of financial services and a large net external asset position. Over the past year, the current account surplus narrowed moderately to 6.8% of GDP in 2023 from 7.7% in 2022 as robust private consumption led to a rising deficit in the goods balance (excluding merchanting). Looking ahead, the economy is projected to continue to register large current account surpluses, with the IMF forecasting an average surplus of 7.5% of GDP during 2024 and 2025. The country also remains a net external creditor, with the net international investment position (NIIP) standing at 33.8% of GDP in December 2023. 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 Morningstar DBRS' positive adjustment of the `Balance of Payments' building block assessment.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

Environmental (E) Factors
There were no Environmental factors that had a relevant or significant effect on the credit analysis.

Social (S) Factors
There were no Social factors that had a relevant or significant effect on the credit analysis.

Governance (G) Factors
There were no Governance factors that had a relevant or significant 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) https://dbrs.morningstar.com/research/427030/morningstar-dbrs-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.

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in Euros 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 (06 October 2023) https://dbrs.morningstar.com/research/421590/global-methodology-for-rating-sovereign-governments. 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 Luxembourg Ministry of Finance (Stability Programme 2024, April 2024; Budget 2024, April 2024), Trésorerie de l'Etat, National Institute of Statistics and Economic Studies of the Grand Duchy of Luxembourg STATEC (Conjuncture Flash April 2024; Statistical tables), Banque Centrale du Luxembourg, Commission de Surveillance du Secteur Financier (CSSF), European Systemic Risk Board (ESRB Risk Dashboard March 2024), Eurostat, European Commission (European Economic Forecast, Winter 2024, February 2024), European Central Bank (Statistical Data Warehouse), OECD (Housing Prices), BIS, IMF (Luxembourg: Staff Concluding Statement of the 2024 Article IV Mission, March 2024; World Economic Outlook April 2024; International Financial Statistics), World Bank, European Environment Agency (EEA Effort Sharing Decision Dataset, October 2023), Social Progress Index, 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: NO
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/432518/.

This credit 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, Global Sovereign Ratings
Initial Rating Date: December 16, 2016
Last Rating Date: November 10, 2023

DBRS Ratings GmbH
Neue Mainzer Straße 75
60311 Frankfurt am Main Deutschland
Tel. +49 (69) 8088 3500
Geschäftsführer: Detlef Scholz
Amtsgericht Frankfurt am Main, HRB 110259

For more information on this credit or on this industry, visit dbrs.morningstar.com.