DBRS Morningstar Confirms Grand Duchy of Luxembourg at AAA, Stable TrendSovereigns
DBRS Ratings GmbH (DBRS Morningstar) confirmed the Grand Duchy of Luxembourg’s Long-Term Foreign and Local Currency – Issuer Ratings at AAA. At the same time, DBRS Morningstar 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 RATING CONSIDERATIONS
The confirmation of the Stable trend reflects DBRS Morningstar’s view that the credit fundamentals of Luxembourg remain solid. The economy has so far weathered the energy price shock and the increase in interest rates well. Real GDP expanded by 1.5% in 2022, driven by resilient consumer spending on the back of a strong labour market and fiscal support measures. Looking ahead, real GDP is expected to continue to grow. The diverging trends in monetary and fiscal policies, however, are likely to exert opposing impacts on growth dynamics. On the one hand, DBRS Morningstar takes the view that the additional tightening of monetary policy in the Euro area over recent months is likely to dampen investment activity further. On the other hand, consumer spending is likely to be bolstered by a step-up in fiscal support measures in 2023. The adoption of these measures is projected to raise budgetary pressures moderately over the next years. The general government budget balance is forecast to turn from a surplus of 0.2% of GDP in 2022 into moderate deficits of 1.5% in 2023 and 1.7% in 2024. In DBRS Morningstar’s view, Luxembourg has ample fiscal space for absorbing a temporary increase in budgetary pressures due to a low level of public debt and a large stock of government assets.
The ratings reflect Luxembourg’s very strong public finances. The 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.
Given Luxembourg’s strong fundamentals, DBRS Morningstar sees a downgrade of the 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. A downgrade could also come from material damage to Luxembourg’s attractiveness as a business hub. Either of these scenarios could have a significant impact on the economy and on public finances.
Economic Growth Faces Headwinds from Monetary Tightening But Is Supported by Large Fiscal Support Measures
Economic growth dynamics softened over the past year. Real GDP growth decelerated to 1.5% in 2022, from 5.1% in 2021 as the growth rebound from COVID-19 faded and tightening financial conditions led to a marked weakening of investment activity. The main growth drivers were government and household consumption, despite a sharp deterioration of consumer sentiment on the back of rising inflationary pressures. On the supply side, the economic growth slowdown was particularly pronounced in the financial sector. Looking ahead, real GDP is expected to continue to grow in 2023, although the pace of expansion is subject to uncertainty as monetary and fiscal policy are moving in opposing directions. On the one hand, the additional tightening of monetary policy in the Euro area over the past few months is likely to continue to weigh on investment activity. DBRS Morningstar also notes that early indicators such as monthly net service exports point to a continued weakness of financial sector activity in early 2023. On the other hand, household spending is likely to be supported by the recent implementation of additional fiscal support measures such as a temporary reduction of VAT rates and the introduction of gas and electricity price caps. In addition, household purchasing power is benefitting from the strong labour market and the recent slowdown in inflationary pressures. The government’s recently released stability programme projects an acceleration of real GDP growth to 2.4% in 2023 whereas the IMF forecasts a modest deceleration to 1.1%.
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 25.2% of total nominal gross value added in 2022 and constitute, together with business services (10.8%), the backbone of the economy. While ongoing changes in global corporate taxation could affect the economic activities in certain segments of the financial sector, DBRS Morningstar 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 DBRS Morningstar’s positive adjustment of the ‘Economic Structure and Performance’ building block.
General Government Budget Balance Is Forecast to Post Moderate Budget Deficits Over the Next Years
Budgetary outcomes weakened slightly in 2022 but continued to compare favourably with those of other highly rated sovereigns. The general government budget surplus narrowed to 0.2% of GDP in 2022 from 0.7% in 2021. Furthermore, DBRS Morningstar notes that fiscal metrics weakened less than expected not least as a result of strong government revenue growth. The government’s draft budget 2023 from October 2022 had forecast a general government budget deficit of 0.4% of GDP for 2022. The narrowing of the budget surplus over the past year resulted primarily from a rising public wage bill and the adoption of support measures for households and companies, the fiscal cost of which is estimated at 1.1% of GDP in 2022. Looking ahead, the government’s stability programme, released in April 2023, forecasts the general government budget balance to post moderate deficits of 1.5% of GDP in 2023, 1.7% in 2024 and 1.0% in 2025. This results from a step-up in fiscal support measures in 2023, most of which are planned to remain in place until end 2024. The fiscal cost of support measures is estimated at 2.0% of GDP for 2023. Furthermore, a regular adjustment of personal income tax brackets from 2024 onwards is set to weigh on government tax revenues.
Ratings Continue to Be Underpinned by Low Public Debt and Large Government Assets
The government debt-to-GDP ratio remains among the lowest in Europe. Although the government’s debt stock is projected to increase moderately over the next years, the government debt-to-GDP ratio is expected to remain below the country’s own ceiling of 30% of GDP. The recently released stability programme 2023 projects general government debt to increase to a still modest 28.2% at end-2025 from 24.6% at end-2022. Moreover, the government’s repayment capacity is bolstered by large government assets. At end-2022, the general government had a net asset position of 8.5% of GDP (excluding government shareholdings in several commercial and non-commercial companies). Therefore, DBRS Morningstar assesses Luxembourg’s fiscal space as very large.
The Ratings Are Supported By High Institutional Quality And Stable Political Environment
Luxembourg’s ratings are underpinned by a stable political environment and a high institutional quality. Although the next general elections are scheduled for October 2023, DBRS Morningstar takes the view that policy predictability 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 current government coalition, which comprises centre-left and centre-right parties (Luxembourg Socialist Workers’ Party, the Greens, Democratic Party) was formed in the aftermath of the October 2013 general elections and was re-elected in 2018. The country is also 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 Sound but Risks Might Emerge from Elevated Housing Prices and Rising Interest Rates
DBRS Morningstar assesses the overall financial condition of the economy’s large banking sector as sound. Banks have comfortable liquidity positions and benefit from good capital buffers, which are an important cushion against a potential weakening of asset quality in the future. The average capital adequacy ratio of banks amounted to 22.8% in December 2022. The stock of non-performing loans is low but DBRS Morningstar views a potential correction of domestic housing prices in tandem with rising interest rates as a potential risk factor for banks’ asset quality. Housing prices have increased markedly over the past years, clearly exceeding the increases in rents and incomes.
Furthermore, the recent increase in interest rates might strain the repayment capacity of some mortgage debtors. Around 46% of total new mortgage loans which have been extended to households since 2012 have fixed the initial interest rate only up until one year, exposing these mortgage borrowers to increases in interest rates. At the same time, repayment capacity of most households is supported by large household assets and a strong labour market. Households’ aggregate financial net worth (excluding pension and insurance claims) amounted to 58% of GDP in 2022. In terms of international risk factors, the increase in global interest rates, together with global financial volatility, could have an effect on the performance of the large investment fund industry. In this regard, however, DBRS Morningstar notes that the increase in global financial volatility in March 2023 has so far not led to large net redemptions of fund shares.
The External Position Is Solid and Influenced by the Multinational Sector
Luxembourg’s external position benefits from persistent current account surpluses and a large net external asset position. Between 2012 and 2022, the economy’s current account surplus averaged 4.5% of GDP, driven by sizeable net exports of financial services. The country also remains a net external creditor, with the net international investment position (NIIP) standing at a large 28.2% of GDP at end 2022. 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 DBRS Morningstar’s positive adjustment of the ‘Balance of Payments’ building block.
ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
There were no Environmental/ Social/ Governance 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 (17 May 2022) at https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-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: https://www.dbrsmorningstar.com/research/413886.
EURO AREA RISK CATEGORY: LOW
All figures are in euros (EUR) 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 (29 August 2022), https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments. In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings, https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-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:
The sources of information used for this rating include Luxembourg Ministry of Finance (Stability Programme 2023, April 2023; de Budget 2023, October 2022), Trésorerie de l'Etat, National Institute of Statistics and Economic Studies of the Grand Duchy of Luxembourg STATEC (Conjuncture Flash April 2023; Statistical tables), Banque Centrale du Luxembourg (Revue de stabilité financière 2022; Statistical tables), Commission de Surveillance du Secteur Financier (CSSF), European Systemic Risk Board (ESRB Risk Dashboard March 2023), Eurostat, European Commission (European Economic Forecast, Winter 2023; Assessment of the Final National Energy and Climate Plan for Luxembourg, 14 October 2020), European Central Bank (Statistical Data Warehouse), OECD (Housing Prices), BIS, IMF (Luxembourg: Staff Concluding Statement of the 2023 Article IV Mission, 10 March 2023; World Economic Outlook April 2023; International Financial Statistics), World Bank, European Environment Agency (EEA Effort Sharing Decision Dataset, October 2022), Social Progress Index, 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: 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.
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. For further information on DBRS Morningstar 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 rating assumptions can be found at: https://www.dbrsmorningstar.com/research/413885.
This 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, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: 16 December 2016
Last Rating Date: 11 November 2022
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