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

DBRS Ratings GmbH (Morningstar DBRS) 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 CREDIT RATING CONSIDERATIONS
Morningstar DBRS 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 credit 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.

CREDIT RATING DRIVERS
The credit ratings 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.

CREDIT RATING RATIONALE

Cyclical Headwinds Are Likely to Fade but Economic Outlook of Euro Area Countries Is Exposed to Downside Risks

Cyclical headwinds for Euro area economies are likely to soften in 2025, driven by a further gradual easing in monetary policy and strengthening domestic demand. At the same time, the economic outlook continues to be exposed to downside risks such as an escalation of geopolitical tensions. Furthermore, a potential increase in global trade tensions might weaken export activity and business sentiment particularly in export-dependent economies. The phasing-in of the new EU fiscal rules has raised consolidation pressures on EU sovereigns although the fiscal adjustment needs vary markedly across countries. Morningstar DBRS 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 divergence may give rise to further Euroscepticism and could bring new challenges to additional European integration. In this regard, Morningstar DBRS notes that eurosceptical parties have become more popular in certain EU countries over the past few years.

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

At the same time, Morningstar DBRS expects the commitment of European policymakers towards the Monetary Union and economic cohesion in European Union (EU) economies to remain very high. This commitment was exemplified in the past by substantial support measures during the Euro area sovereign debt crisis 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 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 has tapped into this credit line.

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 Morningstar DBRS' assessment of the shareholders' commitment to the institution. While the ESM reform has been formally agreed by the Eurogroup on 30 November 2020, there is currently uncertainty as to whether it will come into effect in the near future as the Italian parliament has voted against the ratification of the revised ESM treaty in December 2023. Italy (BBB (high), Positive) is the only member country that has so far not completed the ratification of the revised ESM Treaty. The reform will only be effective once all ESM member countries have ratified it. 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 Core Shareholders' Creditworthiness and Their Commitment to the Institution

Morningstar DBRS defines the ESM's core shareholder group as the Federal Republic of Germany (AAA, Stable), the Republic of France (AA (high), Stable), the Republic of Italy (BBB (high), Positive) and the Kingdom of Spain (A (high), Stable). The weighted median shareholder credit rating of this group, which is the primary driver of the Support Assessment, currently stands at AA (high), in line with France's credit rating. Despite the AA (high) weighted median core shareholders' credit rating, Morningstar DBRS 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 shareholder 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 strong capital buffers which comprised EUR 80.6 billion in paid-in capital and a further EUR 627.9 billion in committed callable capital in December 2023. The paid-in capital accounts for a very large 103.4% of the ESM's current loan book of EUR 78.0 billion and 16% of its total lending capacity of EUR 500 billion, of which EUR 422.0 billion is available for new lending. Croatia's accession to the institution in March 2023 has raised capital buffers. The country's total capital subscription stands at EUR 3.7 billion which includes EUR 422.3 million in paid-in capital. Croatia's contribution to the paid-in capital is payable in five annual installments. The first installment of EUR 84.5 million was paid on 30 March 2023.
The ESM's loan portfolio is characterised by a high degree of concentration in the Hellenic Republic (BBB (low), Positive), representing 76.7% of the total, Spain with 15.2% and Cyprus (BBB (high), Positive) with 8.1%. However, 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

A potential future extension of ESM lending is unlikely to challenge that assessment as long as other safeguards remain in place. Morningstar DBRS 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's 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, the ESM's preferred creditor status supports the institution's Intrinsic Assessment by providing additional protection compared to unsecured creditors. Morningstar DBRS, 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, 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 Factors in Credit Ratings (13 August 2024) https://dbrs.morningstar.com/research/437781.

RATING COMMITTEE SUMMARY
The main points discussed during the Rating Committee include the ESM's loan portfolio and its capital buffers, fiscal and economic developments across Euro area economies, the credit profiles of the ESM's shareholders and the credibility of their support commitment.

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 Supranational Institutions (16 February 2024) https://dbrs.morningstar.com/research/428245. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance 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 the ESM 2023 annual report, the EFSF and ESM Investor Presentation (October 2024), the EFSF and ESM carbon footprint report, the ESM ESG Summary Report 2023, the European Commission's post-programme surveillance report on Greece (November 2024), the European Commission Autumn 2024 forecasts (November 2024). 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: NO
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/446025/.

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: Nichola James, Managing Director, Global Sovereign Ratings
Initial Rating Date: 04 April 2014
Last Rating Date: 19 July 2024

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