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

DBRS Ratings GmbH (Morningstar DBRS) confirmed the Grand Duchy of Luxembourg's (Luxembourg) Long-Term Foreign and Local Currency -- Issuer Ratings at AAA. At the same time, Morningstar DBRS confirmed 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 Luxembourg's credit fundamentals remain very strong. The economy weathered recent shocks well and cyclical headwinds are projected to fade gradually. The National Institute for Statistics and Economic Studies of Luxembourg (Statec) forecasts real GDP growth to accelerate from 1.5% in 2024 to 2.7% in 2025, mainly driven by monetary easing and rising external demand for financial services exports. At the same time, similar to other European Union (EU) economies, the outlook is exposed to important downside risks, such as an escalation of geopolitical or global trade tensions. Luxembourg's fiscal results are weaker than in pre-Covid years but compare favorably with those in most other Euro Area countries. The 2025 Budget forecasts a general government budget deficit of 0.6% of GDP in both 2024 and 2025. In Morningstar DBRS' view, Luxembourg has ample fiscal space to accommodate moderate budget deficits over the next few years without putting pressure on the AAA ratings. The share of public debt-to-GDP is low and the government's repayment capacity is bolstered by a large stock of government assets.

The credit ratings reflect Luxembourg's very strong public finances. The credit ratings are also supported by the country's effective governing institutions and stable political environment, advanced and wealthy economy, and strong external position. These credit strengths offset the challenges associated with the economy's small size with limited diversification, vulnerability to external shocks, and exposure to potential financial stability risks.

CREDIT RATING DRIVERS
The credit ratings could be downgraded if there is a severe shock to Luxembourg's large international financial centre, most likely generated by sustained turmoil in financial markets, that has a significant impact on the economy and on public finances. The credit ratings could also be downgraded if Luxembourg's attractiveness as a business hub is damaged in such a material manner that it impacts the economy and public finances significantly.

CREDIT RATING RATIONALE

Economic Growth is Projected to Recover Gradually But Downside Risks Remain

Economic growth dynamics have strengthened in recent months. After contracting by 1.1% in 2023, real GDP expanded by 0.7% on a quarter-on-quarter basis in Q1 2024 and by 0.6% in Q2 2024 on the back of a moderate recovery in non-construction investment and service exports. Moreover, private consumption continued to expand at a robust pace, underpinned by fiscal support measures for households and employment growth. On the production side, the most important growth drivers during the first half of 2024 were financial services, trade and information and communication, whereas gross value added in the construction sector continued to decrease. On an annual basis, Statec forecasts real GDP growth at 1.5% in 2024 before accelerating to 2.7% in 2025. The projected strengthening of growth dynamics in 2025 is based on the expectation that external demand, particularly for service sector exports, will continue to strengthen and that construction investment will start to recover on the back of monetary easing.

Luxembourg's credit profile is supported by its highly developed economy and its position as a global financial centre. The economy's GDP per capita amounted to EUR 120,019 in 2023. The country hosts a very large fund industry and numerous international banks and insurers. Financial sector activities accounted for 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 believes that Luxembourg is likely to remain highly attractive as a financial hub 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.

Modest Budgetary Pressures are Projected to Ease in 2024 on the Back of Strong Revenue Growth

Luxembourg's fiscal balances are weaker than in pre-pandemic years but continue to compare favorably with most other Euro Area countries. The general government budget balance registered a deficit of 0.7% of GDP in 2023 compared to an average fiscal deficit of 3.6% for Euro area economies. The government expects the deficit to narrow to 0.6% in 2024. While nominal spending levels have been pushed up by the indexation of social benefits and public wages to inflation, this has been more than offset by strong revenue growth, particularly with regard to income taxes. During the first half of 2024, total general government revenues rose by 8.6% on a year-on-year basis compared to an increase of 5.1% for government spending. In light of strong revenue growth, Morningstar DBRS takes the view that fiscal outcomes in 2024 are likely to exceed government projections.

Fiscal accounts this year continue to be negatively affected by energy and non-energy support measures for households and businesses. Assessing the first nine months of 2024, Morningstar DBRS estimates that the fiscal cost for the support measures will be at 1.6% of GDP for full year. While most energy support measures are planned to be phased out by the end of 2024, the adoption of new tax measures in fiscal year 2025 is projected to weigh on government revenues. This includes an adjustment of personal income tax brackets by 2.5 wage-indexations and the reduction of the statutory corporate income tax rate by one percentage point. Furthermore, the government seeks to bolster activity on the domestic housing market through a large housing acquisition program of dwellings under construction with total investments of up to EUR 0.5 billion until 2027. The 2025 Budget forecasts the general government budget deficit at 0.6% of GDP in 2025 and 0.5% in 2026.

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

Luxembourg's low public debt burden is a key strength of the credit rating. General government gross debt amounted to 26.8% of GDP in June 2024. The 2025 Budget forecasts gross public debt to stabilize at 27.5% in 2024 and 2025, and to decline to 27.2% at the end of 2026. Similar to the previous government, the current government follows a prudent fiscal policy. Apart from a low level of debt, the government's repayment capacity is bolstered by large government assets. At the end of 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.

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

Morningstar DBRS assesses the overall financial condition of the economy's large banking sector as strong. Banks have comfortable liquidity positions and benefit from good capital buffers. Furthermore, the current stock of non-performing loans is low. However, the increase in interest rates might strain the repayment capacity of some borrowers and create some pockets of vulnerability with regard to asset quality. Between August 2022 and August 2024, the average interest rate on outstanding loans to households and non-financial corporates rose from 2.3% to 4.1% and from 1.6% to 4.4%, respectively. Furthermore, household debt in Luxembourg is comparatively high standing at 68% of GDP in June 2024 compared to an EU average of 48%. At the same time, the repayment capacity of most households is supported by large household assets and a strong labour market as well as wage indexation. While the large investment fund industry registered net redemptions of fund shares during much of 2022 and 2023, the scale of these outflows was modest and is, therefore, unlikely to have raised liquidity pressures.

The External Position Is Strong and Influenced by the Multinational Sector

Luxembourg's external position benefits from persistent current account surpluses on the back of high net exports of financial services and a large net external asset position. The current account surplus amounted to 6.8% of GDP in 2023 and is projected to remain broadly unchanged with the IMF forecasting surpluses of 6.9% in 2024 and 7.0% in 2025. The country also has a large net asset position, with a net IIP standing at 32.1% of GDP in June 2024. Luxembourg's international investment position is heavily influenced by the activities of multinational companies and the financial sector. It commands a very high net creditor position in direct investments which, according to data by the central bank, largely relates to special purpose vehicles. 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.

Luxembourg's Credit Rating Is Underpinned by High Institutional Quality

High institutional quality is a key strength of Luxembourg's credit profile. The country is a strong performer on the World Bank's Worldwide Governance Indicators, reflecting a high rule of law and low levels of corruption. Furthermore, policy continuity is high. The change in government after the October 2023 elections did not alter the overall direction of government policy, as there is a broad consensus among the main political parties on key policy topics, including fiscal, macroeconomic and foreign affairs. The current government coalition is comprised of the two centre-right parties, the Christian Social People's Party and the Democratic Party. It succeeded the three-party "Gambia" coalition (Luxembourg Socialist Workers' Party, the Greens, Democratic Party) which had governed Luxembourg between 2013 and 2023.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

There were no Environmental, Social or Governance 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 (13 August, 2024) https://dbrs.morningstar.com/research/437781.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/442756.

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 (15 July, 2024) https://dbrs.morningstar.com/research/436000. 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/437781 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 these credit ratings include Luxembourg Ministry of Finance (Budget 2025, October 2024; National Medium-Term Fiscal-Structural Plan, October 2024; Evolution of Revenue and Expenditure as of 30 September 2024, October 2024), Trésorerie de l'Etat, National Institute of Statistics and Economic Studies of the Grand Duchy of Luxembourg STATEC (Conjuncture Flash October 2024; Statistical tables), Banque Centrale du Luxembourg (Financial Stability Review 2024, August 2024; Statistics), Commission de Surveillance du Secteur Financier (CSSF), European Systemic Risk Board (ESRB Risk Dashboard September 2024), Eurostat, European Commission (European Economic Forecast, Spring 2024, May 2024), European Central Bank (Statistical Data Warehouse), OECD (Housing Prices), BIS, IMF (2024 Article IV Consultation Report Luxembourg, June 2024; World Economic Outlook October 2024; International Financial Statistics), World Bank, European Environment Agency (EEA Effort Sharing Decision Dataset, October 2024), Social Progress Index, Macrobond and Haver Analytics. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, these are unsolicited credit ratings. These credit ratings were 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 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 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://www.dbrsmorningstar.com/research/442755.

These credit ratings are endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Yesenn El-Radhi, Vice President, Global Sovereign Ratings
Rating Committee Chair: Michael Heydt, Senior Vice President, Global Sovereign Ratings
Initial Rating Date: 16 December 2016
Last Rating Date: 10 May 2024

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