DBRS Ratings Limited (DBRS) has 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.
DBRS rates the EU at AAA primarily on the basis of its Support Assessment, which is underpinned by the creditworthiness of its core member states and their collective commitment to support the EU's obligations. 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.
The Stable trend reflects DBRS's view that the EU is well positioned to manage near-term risks and its creditworthiness is expected to remain extremely robust despite the United Kingdom's (UK, rated AAA with a Stable trend) departure, as a result of the strong commitment and ability of remaining members to support both the EU budget and its obligations.
The Support Assessment is based on the overall credit quality of the EU's core member states and their collective commitment to support the Union. This is reflected primarily by the weighted median rating of the core member group — the Federal Republic of Germany (AAA with a Stable trend), the Republic of France (AAA with a Stable trend) and the Republic of Italy (BBB (high) with a Stable trend) — which is AAA. This is despite Italy being downgraded to BBB (high) from A (low) on 13 January 2017 as DBRS does not believe this downgrade lessens the EU's overall cohesion. The three core members account for nearly half of all EU contributions and, if other countries' contribution remain unchanged, the three members would likely represent well over half of member contributions following the UK's departure.
Moreover, DBRS believes that the overall political commitment to supporting the institution's key functions is strong. This has been demonstrated by a number of financial support mechanisms used in response to the financial and sovereign debt crises, as well as by the funds that member states contribute to the EU's budget. Furthermore, as established by the founding treaties, EU members share joint responsibility for providing the financial resources required to service the EU's debt.
The EU does not benefit from any paid-in capital. However, its debt-servicing capacity is backed by multiple arrangements that protect creditors. First, all EU borrowings are covered by the EU's available resources, which in 2018 are expected to be 0.91% of the EU's gross national income (GNI), equivalent to EUR 143.6 billion. These funds can be prioritised for debt service whether or not they have been committed elsewhere. Second, if these amounts are insufficient, member states are legally obligated to provide the funds needed to repay the debt and balance the budget up to a 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. DBRS expects that if the UK stopped making contributions to the EU budget, the rest of the members would opt to take over the UK's contribution or reduce the overall budget. However, while net contributors would likely be in opposition to a rise in contributions, budget cuts could be unappealing to the countries that benefit the most from the EU's transfers. This could lead to a revision of the EU's budget rules, with also implications for the upcoming negotiations on the Multiannual Financial Framework (MFF) in 2018. Although uncertainty on the withdrawal negotiations remains elevated, in DBRS's view the potential UK's settlement payment could reduce the impact of the UK departure on the EU's budget.
The EU's conservative budgetary management further supports the ratings. The Union is not permitted to borrow funds for purposes other than to finance its lending programme. 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. 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. Moreover, DBRS 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.
The EU faces several challenges that could affect the credit quality of its core member states or the degree of support. The UK's vote to leave the EU has sparked a period of uncertainty, which is influenced by the withdrawal negotiations. The deal for leaving the EU must be approved by a qualified majority and negotiations could last beyond March 2019 as long as the unanimous consent of the European Council is obtained. In this context, the EU faces a trade-off between taking a tough stance on the conditions under which the UK withdraws, with the aim of maintaining unity among the remaining 27 members, and preparing for the possibility of not reaching a deal. DBRS believes that, despite a more moderate anti-EU stance, the rising support for populist parties in Europe could still threaten the EU's cohesiveness, and that tensions over migration and border security could prove to be divisive and weaken the commitment of individual members towards the EU. Political relations with Turkey and Russia present an additional challenge to forging common policies within the Union. Finally, the ongoing debate over fiscal austerity and banking rules could undermine the integration process.
The EU's highly concentrated lending portfolio represents another challenge. Loans outstanding have increased significantly since 2011, reaching EUR 54 billion in October 2017, up from EUR 13 billion in 2010. Debt-to-revenues increased to 40% from 10% over the same period. This rise is mostly attributable to the European Financial Stabilisation Mechanism (EFSM), under which loans totalling EUR 46.8 billion to Ireland (A (high) with a Stable trend) and Portugal (BBB (low) with a Stable trend) account for 86.7% of total loans. Notwithstanding the relatively high loan concentration, financial assistance programmes are subject to strict policy conditionality, which mitigates credit risks. Over the medium term, DBRS projects EU debt to decline as the European Stability Mechanism (ESM, AAA with a Stable Trend) has assumed primary responsibility for support programmes for Eurozone member states. However, DBRS 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.
RATING DRIVERS
The EU's ratings are driven by the strong, continued political commitment of its member states, which provide the institution with multiple sources of support. However, the EU's ratings could come under downward pressure if one or more of its core members are downgraded, particularly if the credit deterioration raises concerns about the cohesion of the EU as a whole, or weakens core members' political commitment to support the EU. Ratings could also face downward pressure if a rise in Euroscepticism ultimately will result in a material increase of EU's disintegration risk.
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