DBRS Morningstar Confirms the European Union at AAA, Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the European Union’s (EU or the Union) 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 member states' commitment and ability to support the Union is expected to remain strong, despite the rising debt and the new challenges the EU is facing related to Russia's invasion of Ukraine. In response the Coronavirus Disease (COVID-19) shock, the strong cohesion of EU member states enabled the Union to introduce several supporting measures including the Next Generation EU (NGEU) programme. Its financing will lead EU debt to rise significantly in coming years, but it has reinforced the capacity of the EU to mitigate asymmetric impacts. This represents also a strong incentive for member states to remain committed to the EU. New challenges, including the management of Ukrainian refugees, sanctions and reducing energy dependency from Russia, are not expected to weaken EU member states' cohesion or commitment to the EU. DBRS Morningstar views the EU's ability to unveil support measures to cushion the overall economic consequences of the conflict in Ukraine, including the ongoing energy crisis, as strong.

DBRS Morningstar 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. Multiple layers of debt-service arrangements that protect creditors remain in place, despite the significant rise in the debt following the introduction of the NGEU programme, as does the institution’s de facto preferred creditor status.

RATING DRIVERS

The EU’s 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).

RATING RATIONALE

The EU is Well Positioned to Repay Its Rising Debt

The decision regarding the NGEU programme totalling EUR 806.9 billion has expanded previous boundaries related to the EU's common debt and central transfers, reflecting a high degree of cohesion and solidarity among member states. To fund the NGEU programme the EU's debt is rising rapidly, but DBRS Morningstar views positively higher budgetary headroom along with the possible future increase in new revenues to repay debt. EU debt is expected to increase to almost EUR 1 trillion in the coming years from about EUR 249 billion (1.7% of EU27 GNI) in 2021. While loans under NGEU will be paid directly by beneficiaries, the amount of nonrepayable resources, equivalent to EUR 421.1 billion could likely benefit from the anticipated introduction of new EU own resources going forward. Moreover, the increase in the EU's own-resource ceiling (i.e., the maximum level of contributions that member states can pay to the EU budget) to 2.0% (of which 0.6 percentage points on a temporary basis until 2058 for NGEU) of EU's Gross National Income (GNI) from 1.2% provides the EU with significant budgetary headroom to meet its financial commitments.

Russia’s Invasion of Ukraine Adds to Challenges But the EU Member States’ Commitment to EU Obligations is Expected to Remain Strong

The current challenges stemming from the conflict in Ukraine, including sanctions and the ongoing energy shock, are testing cohesion among EU member states. However, DBRS Morningstar expects EU member states' commitment to the Union to remain strong, reflecting the EU's ability to provide support. Nevertheless, so far, the financial support has been moderate and has broadly consisted of making existing support tools, including the state aid rules, more flexible. The EC has also proposed a plan to reduce Russia's fossil fuel dependence and to increase the Recovery and Resilience Facility's (RRF) financial envelope for new grants by EUR 20 billion through the auctioning of emission trading system (ETS) allowances. Additional measures are expected to be introduced going forward, including a revenue cap on ‘inframarginal' electricity producers and taxable surplus profits of the fossil fuel sector. If effective, these could be key to reducing recessionary risks and maintaining a high level of cohesion in the bloc, even though additional measures might be needed.

Future integration in the EU and cohesion will likely be dependent on the success of NGEU. This programme which mostly includes the RRF consisting of EUR 385.8 billion of loans and EUR 338 billion of grants. The programme has been gradually gaining impetus with all member states submitting their plans and with around 5% of total milestones and targets 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 investment and reforms. DBRS Morningstar expects an acceleration in implementation efforts 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 rating is primarily underpinned by its Support Assessment, which reflects the creditworthiness of its core member states - Germany, France (rated AA (high), Stable), Spain (rated 'A', Stable, and Italy (rated BBB (high), Stable), their strong commitment to the Union, and the uplift from multiple sources of support, particularly from non-core AAA-rated member states. DBRS Morningstar views the core shareholders' ability and commitment to support the Union as strong, despite the weighted median rating of AA (high) on the core group. However, the EU enjoys the presence of a set of other AAA-rated member states, whose contributions DBRS Morningstar considers to be sufficient to maintain the EU’s Support Assessment at AAA. DBRS Morningstar 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. Cohesion among member states has been further reinforced by the extraordinary measures taken to counteract the impact of the coronavirus pandemic.

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

The 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 and SURE loan repayments also benefit from a guarantee from EU countries totalling EUR 25 billion, there is a political commitment to reimburse the NGEU nonrepayable resources with new EU own resources. Last year, the EC proposed a set of new EU own resources to be effective gradually starting in 2023. With this proposal, the EC aims to introduce new own resources based on a carbon border adjustment mechanism on a revised EU ETS and on a share of the residual profits from the largest and most profitable multinational enterprises that are allocated to member states following the OECD/G20 agreement ("Pillar One"). This initiative is expected to generate an average of up to EUR 17.0 billion (in constant 2018 prices) annually over the 2026–30 period to finance the Social Climate Fund as well as to repay the nonrepayable component of the NGEU. Moreover, the EC intends to propose an additional basket of EU own resources that could consist of a financial transaction tax and an own resource linked to the corporate sector by the end of 2023. However, agreements on both baskets of new EU own resources might require extensive negotiations among member states.

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 217 billion in 2022) 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 92.8 billion, of which EUR 58.8 stems from core members for 2022). This appears to be comfortable considering that, under this scheme, principal annual debt repayment will not exceed 7.5% or EUR 29.25 billion of the EUR 390 billion in grants (in 2018 prices). Moreover, DBRS Morningstar 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 but Will be Less Geographically Concentrated

The EU’s credit portfolio is rapidly increasing, but its exposure will be more diversified than in the past. However, Italy, Spain, Portugal (rated A (low), Stable) and Ireland (AA (low), Stable) will likely be the largest beneficiaries of both the NGEU and SURE programmes and the legacy European Financial Stabilisation Mechanism (EFSM) programme. As of early September 2022, total EU loans outstanding, including the Euratom programme, sharply increased to around EUR 182.0 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 91.8 billion in outstanding loans, and the NGEU loan disbursements, amounting to EUR 33.4 billion. The rest of the loan book mostly comprises EUR 46.3 billion in loans to Portugal and to Ireland under the EFSM programme. DBRS Morningstar will continue to assess the evolution and concentration of the loan portfolio as EU debt rises.

Despite the Monetary Tightening, EU Continues to Issue A Moderate Costs Which Bode Well for the EU Debt Profile

The European Commission (EC) has been increasing its borrowings markedly since 2020 and it is expected to continue to issue bonds at moderate, although rising costs. Total cost of long-term funding in the first six months of 2022 remained moderated at 1.24% although higher than 0.14% registered in 2021. The tightening in monetary policy will likely not undermine the strong demand that the EU has received so far from a diversified base with a good representation of different types of investors. This will likely be supported by the high volume of green bonds the EC plans to issue, amounting to EUR 250 billion. Moreover, the EU debt benefits from a comfortable average maturity estimated at slightly higher than 11 years, which mitigates the risk of refinancing. DBRS Morningstar views EU debt as enjoying a high degree of predictability with annual NGEU issuances expected to hover around EUR 150 billion and ending in 2026.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Governance (G) Factors
Institutional Strength, Governance and Transparency (G) factor affects 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 and Social factors that had a significant or relevant effect on the credit analysis.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (17, May, 2022).

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 measures in response to the Russian invasion of Ukraine, respect of the rule of law.

Notes:
All figures are in Eur 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 https://www.dbrsmorningstar.com/research/392578/global-methodology-for-rating-supranational-institutions (17, February, 2022). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (17, May, 2022).

The sources of information used for this rating include NextGenerationEU funding plan July-December 22 (June 2022), Semi-annual report on the execution of the NextGenerationEU funding operations pursuant to Article 12 of Commission Implementing Decision C(2021)2502 (June 2022), EU Investor presentation (August 2022), The next generation of own resources for the EU Budget (December 2021), Article 41(5) report (June 2022), Long-term forecast of future inflows and outflows of the EU budget (2021-2027) (June 2021), Long-term forecast of future inflows and outflows of the EU budget (2022-2028) (June 2022), 2021 and 2022 General EU budget, European Commission, AMECO, IMF WEO, Bloomberg, Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this 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

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.

The conditions that lead to the assignment of a Negative or Positive trend are generally 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: https://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/403049.

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

Lead Analyst: Carlo Capuano, Senior Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: July 11, 2014
Last Rating Date: March 25, 2022

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