Scope assigns European Union and Euratom first-time credit rating of AAA with Stable Outlook
For the detailed rating report, click here.
Scope Ratings GmbH has today assigned the European Union and Euratom a first-time AAA long-term issuer and senior unsecured foreign-currency ratings, along with a short-term issuer rating of S-1+ in foreign currency. All Outlooks are Stable.
Scope’s assignment of the European Union’s and Euratom’s AAA rating reflects the supranational’s highly-rated key shareholders, its strong institutional setup ensuring de facto joint and several support, a legally enshrined debt service priority combined with significant budgetary flexibility as well as its conservative cash management resulting in very high liquidity buffers. Given its mandate to lend to crisis countries, the EU’s asset portfolio is usually weak and highly concentrated. In addition, the EU is also exposed to the risk that its guarantees to the EIB’s external (non-EU) and riskier (EFSI) activities will be drawn. Finally, Brexit may result in higher dependence on fewer strong shareholders for budgetary contributions. The Stable Outlook reflects Scope’s assessment of the EU’s inherent buffers to withstand external shocks, including a ‘hard’ Brexit.
The EU’s AAA rating is supported by its highly-rated shareholders. Specifically, the EU’s borrowings are backed by the EU budget which is mostly financed by GNI-based transfers from the EU member states. The seven largest European economies – Germany (AAA/Stable), France (AA/Stable), Italy (BBB+/Stable), the UK (AA/Negative), Spain (A-/Stable), the Netherlands (AAA/Stable) and Belgium (AA/Stable) – together provide around 80% of the EU’s national budgetary transfers, and thus constitute the EU’s key shareholders with a weighted-average rating of AA-.
From this starting point, the EU’s rating is further underpinned by its strong institutional setup. Scope highlights that the EU's debt service ability benefits from multiple layers of protection: First, debt repayments are met using the proceeds of repayments from borrowing countries which received back-to-back financing of loans. However, in case a borrowing country fails to repay its loan to the EU on time, ‘the European Parliament, the Council and the Commission shall ensure that the financial means are made available to allow the Union to fulfil its legal obligations in respect of third parties’. Scope acknowledges this legal debt service priority to third-parties with a 1-notch positive adjustment, taking into account the actual budgetary flexibility of the European Commission to delay significant amounts of the EU’s annual expenditure of about EUR 60bn to 40bn from the European structural and investment funds (ESIFs).
In addition, in case the EU's available cash resources were to be insufficient to cover debt service payments, the European Commission has the legal right to draw funds from all member states. In such an adverse event, the additionally required funds ‘shall be divided among the Member States, as far as possible, in proportion to the estimated budget revenue from each of them’. Specifically, member states are legally obliged to ‘execute the Commission's payment orders following the Commission's instructions and within not more than three working days of receipt’. In Scope’s opinion, this is an exceptionally strong and timely guarantee mechanism with a de facto joint and several support framework which is unique among supranationals and which Scope thus assesses positively with an additional 1-notch adjustment. These considerations, together with a track-record of benefiting from Preferred Creditor Status provide the EU with a very strong institutional setup.
The EU’s AAA rating also reflects its conservative liquidity management and budgetary practices which take into account that most expenditures take place during the first quarter of each year while debt redemptions usually follow thereafter and at the beginning of each month when cash balances are highest. Scope notes the EU's very high cash balances throughout the year that easily cover its debt payment obligations even at their peak. During 2018 the average cash balance until November was EUR 20.2bn while the lowest balance was recorded in May at EUR 11.8bn. As of November 2018, the cash balance was up again at EUR 32.2bn. This compares to very modest annual debt obligations in 2019 (EUR 1.5bn) and 2020 (EUR 0.6bn), which are expected to remain below EUR 4bn for the years thereafter.
In addition to the cash balance, Scope also includes the budgetary margin as part of the EU’s liquid assets. This refers to the difference between the maximum resources the EU can draw on from its member states without the need for any subsequent decision by national authorities, the so-called ‘own resources ceiling’, and the actual total expenditure. While the own resources ceiling is legally binding, it has never been used, and thus, Scope’s conservative approach adjusts this margin for the pro-rata budgetary contributions of those member states rated AA- or above, which is currently 67%. On this basis, the budgetary margin for 2018 stood at around EUR 30bn, which, together with the average monthly cash balance of EUR 20.2bn results in liquid assets of around EUR 50bn for the year 2018. These liquid assets easily cover the EU’s total liabilities maturing within 12 months (i.e. not only those related to its borrowings) which amounted to around 45.9bn (2016: EUR 42.3bn) as of December 2017, resulting in one of the highest liquidity coverage ratios among supranationals.
Despite these credit strengths, the EU also faces the following credit challenges: First, Scope notes that, at the time of writing this report, there was no clarity as regards the final outcome of the Brexit negotiations. However, even in the worst case, which is not Scope’s baseline, assuming a complete removal of budgetary contributions by the UK without a compensation from the other shareholders, the relative weights of the remaining 27 members would adjust such that the key shareholder rating would still remain AA-. Still, in the event of the UK not providing any budgetary contributions anymore, the EU would have to rely on fewer shareholders rated AA- or above for budgetary support, which would result in a weaker assessment of the shareholder concentration and a lower budgetary margin.
Second, the mandate of the EU is to lend counter-cyclically to crisis countries resulting in an inherently weak and concentrated asset quality, particularly during times of financial distress. However, Scope notes positively that the EU’s main direct exposure for honouring its borrowings is related to financial assistance provided to Ireland (A+/Stable) and Portugal (BBB/Stable), which, given their combined share of around 90% of the EU’s total exposure coupled with the countries’ strong economic recoveries, mitigates the EU’s credit risk. In addition, Scope notes that despite lending counter-cyclically to countries experiencing economic crises and having a highly concentrated portfolio, the EU has, to date, never suffered a loss on its loan portfolio. This reflects the fact that its loan disbursements depend on the governments’ compliance with the policy conditionality agreed with, and subsequently monitored by, the European Commission in the context of the financial assistance programmes.
Finally, Scope is mindful that the EU’s ultimate credit risk also includes the guarantees provided to the EIB, in the context of the EIB’s activities outside of the EU as well as those classified under the European Fund for Strategic Investments (EFSI). In Scope’s opinion, these meaningful contingent liabilities constitute an important and growing part of the EU’s overall credit risk. In this context, Scope points to i) the deterioration in the asset quality of the operations covered by the Guarantee Fund for External Actions, totalling EUR 33.4bn, in particular, the meaningful EUR 8.9bn exposure to Turkey (BB-/Negative) and ii) the potential risks covered by the EFSI Guarantee Fund which, following its extension in 2017, now provides a EUR 26bn (up from EUR 16bn) guarantee ceiling on the EIB’s related investments which are, on average, riskier than the traditional risk profile of the EIB’s portfolio. The EFSI-related risks refer to the relatively gradual increase of the assets of the EFSI Guarantee Fund (EUR 3.5bn as of December 2017) in relation to the increase of the overall ceiling of the EU’s guarantee and the lack of track record of operations with a comparatively new client base. Despite this exposure, Scope notes that the risk borne by the EU budget is significantly curtailed by i) the assets of the Guarantee Fund for External Actions and the EFSI Guarantee Fund, which, as of December 2017 amounted to EUR 2.5bn and EUR 3.5bn respectively, which would absorb any losses before resources would need to be drawn from the EU budget, ii) the track record of very low defaults, which to date, has been in the magnitude of around EUR 50mn per year, and iii) the EU’s conservative financial management, including ample liquidity buffers and upfront provisioning of the Funds.
Scope’s supranational scorecard
Scope’s supranational scorecard, which is based on clearly defined quantitative parameters, provides an indicative ‘AAA’ rating for the European Union and Euratom. Additional considerations allow Scope to incorporate idiosyncratic characteristics that cannot be assessed in a consistent and comprehensive manner across all supranationals, but which may still affect the creditworthiness of the issuer.
For the European Union, the following additional considerations have been identified: i) debt service priority combined with significant budgetary flexibility; ii) an exceptionally strong and timely guarantee mechanism with a de facto joint and several support framework. Scope acknowledges each factor with a 1-notch positive adjustment.
A rating committee has discussed and confirmed these results.
For further details, please see Appendix I of the rating report.
Factoring of Environment, Social and Governance (ESG)
Scope considers ESG sustainability issues during the rating process as reflected in its supranational methodology. Governance-related factors are implicitly captured in Scope’s assessment of the ‘fundamental rating’, which Scope assesses for the European Union with a AAA. Environmental factors are considered during the rating process, including the risk to ‘stranded assets’ and the benefits from issuing green and/or social bonds but did not have an impact on this rating action.
Outlook and rating-change drivers
The Stable Outlook reflects Scope’s assessment of the EU’s inherent buffers to withstand external shocks, including a ‘hard’ Brexit. The rating could be downgraded if: i) highly-rated key shareholders are downgraded; ii) the institutional setup changes, resulting in a notably weaker support framework; and/or iii) the EU’s liquidity buffers were significantly reduced.
The main points discussed were: i) key shareholders and institutional setup; ii) preferred creditor status and mandated activities; iii) joint and several support mechanism; iv) debt payment priority; v) liquidity management and buffers; vi) contingent liabilities; vii) asset quality; and viii) consideration of peers.
The methodology applicable for this rating and/or rating outlook, ‘Supranational Entities’, is available on www.scoperatings.com. Historical default rates of Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/governance-and-policies/regulatory/esma-registration. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default as well as definitions of rating notations can be found in Scope’s public credit rating methodologies on www.scoperatings.com. The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months.
Solicitation, key sources and quality of information
The rating was not requested by the rated entity or its agents. However, the rated entity and/or its agents did participate in the rating process. Scope had access to accounts, management and/or other relevant internal documents for the rated entity or related third party. The following substantially material sources of information were used to prepare the credit rating: the rated entities,public domain and third parties. Key sources of information for the rating include: European Commission, EIB, Eurostat, Haver Analytics and Bloomberg.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Prior to the issuance of the rating or outlook action, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Rating prepared by Alvise Lennkh, Director
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director
The ratings/outlook were first released by Scope on 01.02.2019.
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.
Conditions of use / exclusion of liability
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