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Rating action

Scope Ratings GmbH has today affirmed the Grand Duchy of Luxembourg’s (Luxembourg) AAA long-term issuer and senior unsecured local- and foreign-currency ratings, along with its short-term issuer rating of S-1+ in both local and foreign currency. All Outlooks remain Stable.

Summary and Outlook

Scope’s affirmation of Luxembourg’s AAA ratings reflects its: i) wealthy, competitive and high value-added economy; ii) robust public finances, characterised by low debt, a good record of consistent fiscal surpluses pre Covid-19, and prudent fiscal management; and iii) a strong external position reflecting its significant net external creditor position. These factors contribute to Luxembourg’s economic resilience and ability to face future shocks, as demonstrated during the Covid-19 crisis. The rating is constrained by: i) a small, open economy that is exposed to developments in global taxation frameworks and international financial markets; ii) long-term fiscal pressures linked to population ageing and generous social security systems; and iii) rising financial vulnerabilities linked to rapidly increasing real estate prices and elevated private debt levels.

The Stable Outlook reflects Scope’s view that risks to the ratings are balanced over the next 12 to 18 months.

The rating/Outlook could be downgraded, if individually or collectively: i) Luxembourg’s economic outlook deteriorates substantially; ii) fiscal fundamentals weaken substantially; and/or iii) vulnerabilities in the financial system were to threaten the country’s macro-economic stability.

Rating rationale

Luxembourg’s AAA ratings are supported by its wealthy, competitive and high value-added economy. The country has one of the highest GDP per capita at EUR 108,000 (at purchasing power parity) in the world. Luxembourg’s economy is characterised by high value-added activities given its status as a global financial centre, sound policymaking and strong institutions, dynamic job creation and robust growth. Over the 2015-19 period, real growth averaged 3.2%, among the highest of its peers after Ireland (10%) and Estonia (3.8%). The country’s good economic fundamentals and its swift, forceful and effective policy response to the Covid-19 crisis resulted in a remarkably mild recession in 2020 of only 1.3%.

The resilience of the Luxembourg economy in 2020 reflects strong performance in the information and communication sector and the country’s large financial sector, which adapted quickly to teleworking and were less affected by the crisis than contact-based services. Economic activity has been recovering quickly, exceeding pre-crisis levels in 2021 following estimated growth of 6.9%. Scope expects growth to moderate to around 3.2% in 2022 before converging back to Luxembourg’s long-term potential of 2.4%. Short-term risks to the outlook remain, however. Though direct exposures are limited, the Russian invasion of Ukraine is exacerbating inflationary pressures while the tightening of global financial conditions could negatively impact the country’s financial sector and slow economic recovery.

The AAA ratings are also underpinned by Luxembourg’s robust public finances. The country has a good record of consistent budget surpluses and overachieving its medium-term budgetary objectives. The budget balance averaged 2% of GDP over the 2015-19 period, reflecting very prudent fiscal management and strong tax revenues. Luxembourg implemented a large fiscal support package in response to the Covid-19 crisis, totalling 19% of GDP (5% of GDP in direct outlays, 8% in tax deferrals and 6% in public guarantees). This resulted in a deficit of around 4% of GDP and an increase in public debt of 2.8pps of GDP, considerably lower than initial forecasts and also below that of several euro area peers.

The government’s medium-term budgetary strategy has been designed to fully align with the budgetary guidelines set by the European Commission and balances the need to provide discretionary support for the economic recovery and return public finances to a sound footing, in line with EU fiscal rules. Importantly, the budget balance returned to a surplus in 2021 at 0.5% of GDP, well ahead of previous estimates due to a much faster than anticipated recovery in revenue, almost 15% above what had been budgeted. Scope expects public debt to stabilise at around 22% of GDP over the medium term, among the lowest in Europe and broadly in line with pre-crisis levels. The sovereign balance sheet is further bolstered by large government financial wealth, with assets worth 45% of GDP, of which 35% of GDP are invested through the pension reserve fund. These factors provide Luxembourg with ample fiscal buffers to face future shocks as well as long-term age-related fiscal pressures, a key credit strength.

Finally, the AAA ratings are bolstered by a strong external position. Luxembourg has consistently generated current account surpluses, averaging 4.8% of GDP over 2015-19. Sustained current account surpluses have resulted in a large positive net international investment position of around 39% of GDP as of September 2021. The current account balance deteriorated during the Covid-19 crisis, dipping to a modest deficit (-0.1%) in the year to June 2021 but has since recovered to a 1.7% surplus in the 12 months to September 2021. Looking ahead, Scope expects the surplus to grow and exceed 4% of GDP, though it should be negatively impacted in the short-term by the repercussions of Russia’s invasion of Ukraine. Direct exposure to Russian energy imports is limited compared to peers, but the impact of the conflict on global energy prices is likely to weigh on Luxembourg’s current account balance through a higher import bill.

Despite these considerable credit strengths, Luxembourg faces several challenges.

First, as a small, open economy with a large financial sector, Luxembourg is subject to macro-economic volatility and exposed to developments in the external environment. Changes in the global tax environment may weigh structurally on the country’s growth outlook and fiscal performance, as highlighted by the IMF¹. The OECD-led global tax deal could have adverse repercussions for Luxembourg which maintains a competitive tax landscape and relies heavily on tax revenue from corporate income and gains (15% of total revenue in 2019). However, the final impact of Luxembourg’s economy and fiscal performance could be mitigated by several factors. The regulated financial sector is expected to be excluded from Pillar One of the OECD-led agreement, while Luxembourg’s statutory and effective tax rates remain well above the Pillar Two minimum rate of 15% at 24.9% and 22.8% respectively. In addition, Luxembourg has considerable non-tax advantages such as its status as a global financial hub with a well-established ecosystem, a skilled multilingual workforce, and a stable political and social environment.

Second, Luxembourg faces substantial long-term age-related spending pressures. It is one of the EU countries that will see the largest increase in healthcare, pensions and education costs due to population ageing, estimated at 6.3pps of GDP by 2050 (versus an EU average of 2.5pps). Age-related fiscal pressures are slightly worse than for peers, reflecting generous social security systems, even though the country benefits from more favourable demographics. The old-age dependency ratio is expected to rise to 43.8% by 2050 from 22.3% in 2020, well below the peer average. These spending-related pressures and associated budgetary risks are largely mitigated by Luxembourg’s very strong fiscal position.

Finally, financial sector vulnerabilities continue to build up and could pose a risk to Luxembourg’s macro-financial stability. Growth in housing prices has accelerated in recent years owing to strong demographic and economic growth, increasing mortgage debt combined with supply-side constraints. Residential prices have continued to grow despite the Covid-19 crisis, with the Eurostat house index in September 2021 22% above pre-crisis levels. In addition, household debt and non-financial corporate debt are high, at around 175% of disposable income and 3.7 times GDP respectively. Luxembourg’s large financial sector is also highly integrated in, and thus exposed to global financial market risk. In a recent report on EU financial market risk, the European Securities and Markets Authority assesses the risks of possibly significant market corrections which could impact institutional and retail investors². Still, financial system risks are mitigated by effective oversight frameworks, a resilient banking sector, and high, albeit unevenly distributed, household wealth.

Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides an indicative credit rating of ‘aaa’. The methodology’s reserve currency adjustment provides a one notch uplift to the CVS indicative has no impact on Luxembourg’s indicative which is already at the highest point of Scope’s rating scale. The ‘aaa’ indicative ratings can thereafter be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses against a peer group of countries.

For Luxembourg, the following relative credit strengths via the QS have been identified: i) growth potential; and ii) debt sustainability. Conversely, the following relative credit weaknesses have been identified: i) macro-economic stability and sustainability; and ii) financial imbalances.

Combined relative credit strengths and weaknesses identified in the QS result in no adjustment to the ratings and indicate a sovereign credit rating of AAA for Luxembourg.

A rating committee has discussed and confirmed these results.

Factoring of environment, social and governance (ESG)

Scope explicitly factors in ESG sustainability issues during its rating process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 20% weighting under the quantitative model (CVS) as well as in the methodology’s qualitative overlay (QS).

Under governance-related factors captured in Scope’s Core Variable Scorecard (quantitative model), Luxembourg holds strong scores on a composite index of six World Bank Worldwide Governance Indicators, reflecting strong democratic institutions. Furthermore, Scope’s Qualitative Scorecard evaluation on ‘institutional and political risks’ indicates Luxembourg as in line with performance of ‘aaa’ indicative sovereign peers, reflecting stable political conditions and broad consensus on key policy issues, including European integration. Xavier Bettel has been prime minister since 2013 and was confirmed after the 2018 elections, with support from a coalition formed by his party (the Democrats), the Socialist Party and the Greens. The next elections are scheduled for 2023.

As regards social-risk factors, the quantitative model score is constrained somewhat by an ageing society in an international context, reflecting an increasing old-age dependency ratio over the long-term. The country has above average scores on income inequality and labour force participation rates. Social outcomes are strong in an EU context though poverty levels and income inequality have worsened over the past decade. The proportion of people at risks of poverty or social exclusion stood at 20.9% in 2020, up from 17.8% in 2009. Similarly, the S80/S20 ratio increased from 4.3 to 5.0, while the income share of the bottom 40% shrank from 22.2% to 20.6% over the same period. While Luxembourg benefits from more favourable demographic dynamics than European peers, the generosity of its social systems could come under strain in the context of population ageing. The EU commission expects the cost of population ageing to grow by about 6.3pps of GDP over 2019-50, one of the largest increases among EU-peers.

Finally, on the sovereign ESG pillar’s environmental risk sub-category, Luxembourg’s quantitative scores are strong in terms of the CO2 intensity of its economy (as measured by emissions per unit of GDP) and as regards natural risks. However, its large deficits of the footprint of consumption relative to available biocapacity, given the physical constraints of its geography, result in a weak score for resource risks. In per capita terms, Luxembourg has some of the highest greenhouse gas emissions per capita in the EU, generating 0.34% of the EU’s total greenhouse gas emissions despite only accounting for 0.14% of total EU population. Its energy mix mostly made up of fossil fuels (78% of total primary energy supply in 2018), including the largest share of oil among IEA member countries (60%). It is also highly dependent on resource imports given its small, natural resource poor territory. The government has adopted ambitious energy sector targets for 2030 to reduce non-ETS emissions by 50-55% versus 2005, (above the 40% reduction required by the EU). It plans net-zero greenhouse gas emissions and 100% renewable electricity by 2050. The country has adopted measures that will help reach its emissions target, including the introduction of a carbon tax in January 2021 which was increased in 2022 to EUR 25 per tonne and will increase further over the medium term.

Rating Committee
The main points discussed by the rating committee were: i) economic performance and outlook; ii) fiscal developments and debt trajectory; iii) financial system risks; iv) external position; and v) environmental and social risks.

Rating driver references
1. IMF (2020), International Taxation and Luxembourg’s Economy
2. ESMA (2022), Report on Trends, Risks and Vulnerabilities No.1, 2022

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sovereign Ratings, 8 October 2021), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies
Scope Ratings GmbH and Scope Ratings UK Limited apply the same methodologies/models and key rating assumptions for their credit rating services, while Scope Hamburg GmbH’s methodologies/models and key rating assumptions are different from those of Scope Ratings GmbH and Scope Ratings UK Limited.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With Rated Entity or Related Third Party Participation    NO
With Access to Internal Documents                                 NO
With Access to Management                                           NO
The following substantially material sources of information were used to prepare the Credit Ratings: public domain.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data. Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks is/are UK-endorsed.
Lead analyst Thibault Vasse, Senior Analyst
Person responsible for approval of the Credit Ratings: Alvise Lennkh, Executive Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 19 October 2018.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures 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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