DBRS Morningstar Confirms the European Union at AAA, Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the European Union’s (EU) Long-Term Issuer Rating at AAA and 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 the EU is well positioned to manage near-term risks including the impact of the new Coronavirus Disease (COVID-19) on its 27 economies and the uncertainty regarding the EU Budget after the end of the United Kingdom’s (U.K., rated AAA with a Stable trend by DBRS Morningstar) transitional period. The COVID-19 spread is an unprecedented shock for the member states, but a combination of monetary and fiscal actions at the EU level is gradually forthcoming. This will mitigate the impact of the outbreak and help EU economies to steadily rebound. However, the magnitude of the spread of the virus could require an additional joint effort to find shared solutions in order to reduce the economic and social costs of the pandemic. In the absence of a compromise, cohesion among EU countries might be weaker and Euroscepticism could rise. However, historical evidence provides comfort that EU member states facing extraordinary shocks remain strongly committed to the Union. At the same time, the EU27 members' ability and commitment to support both the EU budget and its obligations is projected to remain strong even post-Brexit. A combination of lower expenditures and higher revenues from the remaining members will likely mitigate shortfalls in the budget stemming from the U.K.'s departure.

DBRS Morningstar rates the EU at AAA primarily based on its Support Assessment. This is underpinned by the creditworthiness of its core member states and their strong, continued political commitment to support the EU’s obligations, which provide the institution with multiple sources of support. The ratings also benefit from the EU’s conservative budgetary management with multiple arrangements that protect creditors as well as the institution’s de facto preferred creditor status.

RATING DRIVERS

The EU’s ratings could be downgraded if one or more of its core members are downgraded or if a marked deterioration in creditworthiness of a single core shareholder occurs, particularly if it raises concerns about the cohesion of the EU as a whole, or weakens core members’ political commitment to support the EU. Ratings could also be downgraded if a rise in anti-EU sentiment due to lack of cohesion ultimately results in a material increase in the risk of the EU’s disintegration.

RATING RATIONALE

COVID-19 is a Key Threat to European Healthcare Systems and Economies

The rapid spread of the COVID-19 disease is an unprecedented threat to the EU member states that now face increasing pressure on both their healthcare systems and their economies. Against this background, the lack of cohesion among member states in delivering a broad and coordinated response could ultimately indicate a lower commitment to the Union and the EU's integration project. However, given recent actions, DBRS Morningstar is of the view that the EU and national governments will work together to mitigate the impact of COVID-19 on their economies and their commitment to support the EU will remain strong. Historical evidence has already demonstrated the EU's ability and willingness to put in place new tools and take key decisions to face important crises including the Global Financial Crisis (GFC) and the sovereign debt crisis in 2008-2009 and 2011-2012, respectively.

In recent weeks, the EU authorities have announced several measures including, EUR 37 billion of funds from the EU budget, up to EUR 28 billion from yet unallocated funds from the 2014-2020 Multiannual Financial Framework (MFF), and up to EUR 800 million from the EU solidarity Fund to fighting the COVID-19 outbreak. In parallel, beyond the expansionary measures from the European Central Bank (ECB), the Eurogroup agreed on the activation of the general escape clause of the Stability and Growth Pact, that means placing a “pause” to the adjustment to fiscal targets. However, as the consequences of the national restrictive measures to contain the COVID-19 spread continue to put pressure on EU member states’ economies, DBRS Morningstar is of the view that additional decisions could be taken. These might include the involvement of the European Stability Mechanism (ESM, rated AAA with a Stable trend), Euro bond issuances, an expansion of the EU budget or other measures. EU member states face challenges also on several matters, including migration, fiscal and foreign policy and border security and, in the absence of a reasonable compromise, their individual commitment towards the EU could ultimately weaken.

The U.K. Exit Will Prompt Changes But Does Not Affect Member States’ Commitment to the Union

Beyond the impact of the COVID-19 outbreak, the EU faces additional challenges, including the high degree of uncertainty regarding the new future relationship with the U.K. after the transitional period. According to the withdrawal agreement, the U.K. is expected to contribute to the EU budget until 31 December 2020 and to continue to pay its share of the payments deriving from commitments of the 2014-2020 period (and previous periods – the “RAL - Reste A Liquider”) as well as its share of liabilities not covered by corresponding assets (mostly pensions). Negotiations on the future relationship remain complex and DBRS Morningstar anticipates that if required the transitional period might be extended. Furthermore, the U.K. may continue to contribute to the EU budget as a third country when the transitional period expires, although by a reduced amount. The shortfall of its net contributions (totalling around EUR 9 billion on average from 2014 to 2018) are likely to be compensated by the higher funds from the remaining members as well as by a reduction in the expenditure programmes.

This will likely depend on the still ongoing negotiations on the next MFF for the 2021-2027 period, whose outcome in terms of size of the budget and approval remain uncertain. At this stage, the spread of coronavirus will likely require also higher expenditures as the crisis is negatively affecting member states’ economies. At the same time, linking the access to EU funding to the rule of law adds another element of complexity. Negotiations over the next MFF will also be important with regard the EU budget financial exposure which is highly influenced by the growing amount of the RAL. This is the amount of commitments made but not yet paid and might put potentially higher pressure on the EU budget as well as on that of net contributor countries in the future. Nevertheless, DBRS Morningstar anticipated that, although negotiations might be long and complex, as they were for the approval of current MFF (2014-2020), a compromise will be achieved..

Strong Political Commitment to the EU from Core Members Supports the Ratings

DBRS Morningstar primarily rates the EU based on the Support Assessment that reflects the creditworthiness and the commitment of the core member states. In June 2016, DBRS Morningstar removed the U.K. from its group of core members following its decision to leave the EU. The U.K.’s departure from the bloc will effectively increase the relative contributions of its remaining 27 members. It is therefore likely that the EU’s budget contribution key will more closely resemble that of euro area institutions such as the ESM. Consequently, as the exact terms of a U.K. formal exit become clearer, DBRS Morningstar is likely to incorporate Spain (rated A with a Positive trend) as a member of the EU’s core member group. The inclusion of Spain would serve primarily to underscore the capacity and willingness of the largest EU member states to support the institution and would not affect the weighted median rating of the core group (AAA), or DBRS Morningstar’s overall support assessment.

The Support Assessment is reflected primarily by the AAA weighted median rating of the core member group: the Federal Republic of Germany (rated AAA with a Stable trend), the Republic of France (rated AAA with a Stable trend) and the Republic of Italy (rated BBB (high) with a Stable trend). These three core members account for nearly half of all national contributions (49.0%) to the EU budget and, following the U.K.’s formal departure from the bloc, they should remain the largest contributors to the EU’s budget.

DBRS Morningstar believes that the overall political commitment to supporting the institution’s key functions remains strong. This reflects the contribution of EU Member states to the EU’s budget and, as established by the founding treaties and the shared joint responsibility for providing the financial resources required to service the EU’s debt.

Structurally Sound Budgetary Management and De-facto Preferred Creditor Status Support the Ratings Further

Ratings are further supported by the EU’s conservative budgetary management. The Union is not permitted to borrow funds for purposes other than to finance its lending programmes. Lending and borrowing activities follow strict prudential rules, with debt financing typically matching the loans provided in terms of maturity, interest payments and currency. As a result, the EU’s budget does not incur any interest rate or foreign exchange risks. In addition, the MFF provides the general expenditure framework for a seven-year period and establishes ceilings for the commitment and payment appropriations for the annual budgets during that period. This contributes to predictability and discipline.

The EU does not benefit from any paid-in capital. However, its debt-servicing capacity is backed by multiple arrangements that protect creditors. Firstly, all EU borrowings are covered by the EU’s available resources, which in 2020 are estimated to be 0.89% of the EU’s gross national income (GNI), equivalent to EUR 151.6 billion. The available funds can be prioritised for debt service whether or not they have been committed elsewhere. Secondly, member states are legally obligated to provide the funds needed to repay the debt and balance the budget up to the ceiling of 1.20% of the EU’s GNI. If necessary, EU legislation allows member states to contribute more than their share to the EU budget. Moreover, DBRS Morningstar recognises the EU’s 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’s Portfolio has Stabilized but Remains Concentrated Representing a Challenging

Although, remaining relatively stable over the last few years, loans outstanding including the Euratom programme is sizeable at EUR 51.9 billion as of end-February 2020. A large part of the portfolio is mostly attributable to the European Financial Stabilisation Mechanism (EFSM), under which loans that total EUR 46.8 billion to Ireland (rated A (high) with a Positive trend) and Portugal (rated BBB (high) with a Stable trend) account for 90.1% of total loans. Notwithstanding the relatively high loan concentration, financial assistance programmes are subject to strict policy conditionality, which mitigates credit risks. Moreover, the EU operates typically with very sizeable cash balances that exceed maturing debt. Over the medium term, unless additional decisions to support member states will be taken DBRS Morningstar projects EU debt to decline. This is because the European Stability Mechanism has assumed the primary responsibility for support programmes to Eurozone member states. However, DBRS Morningstar expects the EU to remain active in capital markets until at least 2026, given the possibility that Ireland and Portugal could extend their EFSM loan maturities.

ESG CONSIDERATIONS

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

Notes:
All figures are in EUR unless otherwise noted.

The principal methodology is the Global Methodology for Rating Supranational Institutions (3 March, 2020): https://www.dbrsmorningstar.com/research/357589/global-methodology-for-rating-supranational-institutions.

The sources of information used for this rating include EU Investor presentation January 2020, Technical adjustment of the Financial Framework for 2020, Guarantee Fund Balance Sheet (31-12-2019), EU Budget 2020, European Commission, IMF WEO, Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited 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]

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.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are 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:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

The sensitivity analysis of the relevant key rating assumptions can be found at: http://www.dbrsmorningstar.com/research/359272/.

Ratings assigned by DBRS Ratings GmbH are subject to EU and U.S. regulations only.

Lead Analyst: Carlo Capuano, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Initial Rating Date: July 11, 2014
Last Rating Date: October 4, 2019

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