First S&P downgraded the UK, now it’s the EU’s turn.
Long-Term Rating On Supranational Institution The European Union Lowered To ‘AA’ On Brexit Referendum; Outlook Stable
The European Union (EU) supranational borrows on the capital markets to lend to member states and certain other governments on a back-to-back basis. The long-term rating on the EU partly relies on the capacity and willingness of its 28 members to support it. We currently rate the EU at ‘AA’.) OVERVIEW
- After the decision by the U.K. electorate to leave the EU as a consequence of the June 23 consultative referendum, we have reassessed our opinion of cohesion within the EU, which we now consider to be a neutral rather than positive rating factor.
- We think that, going forward, revenue forecasting, long-term capital planning, and adjustments to key financial buffers of the EU will be subject to greater uncertainty.
- As a consequence, we are lowering our long-term rating on the supranational European Union to ‘AA’ from ‘AA+’ and affirming the ‘A-1+’ short-term rating.
- The outlook is stable, reflecting our opinion that under most scenarios, including a U.K. withdrawal from future (though not current) budgetary commitments, our anchor ratings on the EU will remain at the current level of ‘AA/A-1+’.
RATING ACTION
On June 30, 2016, S&P Global Ratings lowered its long-term issuer credit rating on supranational institution, the European Union (EU), to ‘AA’ from ‘AA+’. The ‘A-1+’ short-term rating was affirmed. The outlook is stable.
RATIONALE
The rating action stems from S&P Global Ratings’ view that the U.K. government’s declared intention to leave the union lessens the supranational’s fiscal flexibility, while reflecting weakening political cohesion. As a consequence of the decision by the U.K. electorate to leave the EU following the June 23 referendum, we have reassessed our previously favorable opinion of solidarity within the EU to neutral from positive. Our baseline scenario was previously that all 28 member states would remain inside the EU. While we expect the remaining 27 members to reaffirm their commitment to the union, we think the U.K.’s departure will inevitably require new and complicated negotiations on the next seven-year budgetary framework, known as the Multiannual Financial Framework (MFF), from 2021-2027. Going forward, revenue forecasting, long-term capital planning, and adjustments to key financial buffers of the EU will in our view be subject to greater uncertainty.
The long-term rating on the EU relies on the capacity and willingness of the 10 wealthiest EU members that are net contributors to the EU budget. We calculate the anchor rating on the EU by determining the GDP-weighted rating of these net contributors, which is now ‘AA’. We can modify this anchor rating up or down according to our assessment of:
- The EU’s fiscal flexibility;
- The EU’s large and underfunded pension and other employee liabilities of 58.6 billion as of end 2014 (2015 financial statements have yet to be released);
- The EU’s guarantees given or received;
- Our view of the permanence of the political cohesion in the EU, and the risks to it;
- Revenue forecasting and long-term capital planning; and
- Effective fiscal headroom (accessible committed funds from members) in relation to debt maturities.
The decision to lower the rating reflects our view that the above modifiers now have an overall neutral rather than positive effect.
On June 27, 2016, we lowered the rating on the second-largest net contributor to the EU budget–the U.K.–to ‘AA’ from ‘AAA’ following the U.K. electorate’s decision to leave the EU. That departure will also complicate budgetary and policy priorities among the 27 remaining members of the EU, in our opinion, weakening the EU’s fiscal flexibility and introducing uncertainty into budgetary forecasts. Our baseline expectation is that gross payments of remaining budgetary contributors are likely to be cut in the next MFF as the overall budget is downsized, while wealthier members’ proportional contributions will likely rise to replace lost net financing from the U.K.
We view the EU as the most prominent of the European supranationals. Founded in 1958 by the Treaty Establishing the European Community (The Treaty of Rome), the EU manages a common budget for its members. It administers transfer programs that are policy priorities for its member states; maintains a customs union; and sets common social, environmental, and regional policies. As a lender, the EU focuses on providing financial assistance, primarily (although not exclusively) to EU member states in economic difficulty with limited access to commercial bond markets.
The EU’s financial arrangements are complex. Its liabilities substantially exceed its assets (by €58 billion at year-end 2014). This large net liability position includes material non-current payables and, in particular, future pension payments, a large part of which we believe would be subordinated to debt-servicing requirements if necessary (Treaty on the Functioning of the European Union, Articles 310.1 and 323). This baseline assumption–the priority of debt payments over current expenditures–is a key rating support.
We use our principles of credit ratings to assess the EU as a supranational borrower, owing to the uniqueness of its structure. Although the EU lends to member states, the EU does not resemble a bank: it has no paid-in equity (nor, technically, any callable capital, although it can–as established in the Treaty of the European Union–call upon the resources of member states to service its debt). At the same time, our high credit rating partly recognizes the EU’s de facto preferred creditor treatment. The EU also benefits from several lines of explicit and implicit support by EU member states as stipulated in the Treaty of the European Union.
Unlike most financial entities, including the European Financial Stability Facility (EFSF)–another supranational that has lent to program countries in Europe–the EU does not engage in maturity transformation. All of its loans are equally matched back-to-back by same-maturity borrowings in the market. The EU lends primarily to member states through its balance-of-payments loans to and via its European Financial Stabilization Mechanism (EFSM), lending to two members states, Ireland and Portugal (86.7% of the EU’s loan book), as well as to non-member states via its small-scale macrofinancial lending to Serbia, Bosnia, Macedonia, Albania, Armenia, and Ukraine. The EU also extends its guarantees to several European Investment Bank (EIB) lending programs.
The EU benefits from several credit strengths. The size of the EU’s overall risk assets is limited when compared to EU-28 GDP (€13 trillion or 0.6%) or the EU government bond market (equivalent to €8.4 trillion or 0.9%). We also expect the EU’s lending activities will likely gradually decline, now that the European Stability Mechanism (ESM) is prepared and amply capitalized to provide financial assistance to eurozone member countries. Last year’s bridge loan from the EU to Greece for €7.2 billion was paid back on time and in full, and the EU has no outstanding exposures to Greece.
We expect that the average maturity at disbursement of the EU’s EFSM loan portfolio will increase to 19.5 years (from 12.5 years in 2013), once it extends advances to Ireland and Portugal (assuming their governments make this request as and when current loans from the EU come due). We expect that the EU will continue its back-to-back lending and that it will roll over its debt to match the maturity extensions anticipated in the Irish and Portuguese Troika lending programs. We view as remote the EU not being able to access capital markets.
The EU’s budget consists of annual revenues that we expect will total just under 1% of the total gross national income (GNI) of its member states (€1 trillion) over the 2014-2020 MFF. In case of need, a large part of these revenues could be reallocated for debt service instead of transfers and other current expenses. To ensure funds would be available in such a scenario, the EU has scheduled its debt maturities at the beginning of the month, when its cash balances are maximal. Over the past two years, the beginning-of-month cash balance has been almost always higher than €10 billion. The maximum yearly debt redemption of the EU over the next five years is €7.7 billion.
In addition to these recurrent cash receipts, the EU has a contingent claim (“fiscal headroom”) on EU members, which we expect will average 0.28% of GNI (or about €30 billion annually) over the 2014-2020 MFF. EU members have made this pledge for the express purpose of backing the EU’s financial obligations.
Both this pledge and any budgetary payments are joint and several obligations of EU members. We believe, however, that the willingness of sovereigns rated at or above the level of the rating on the EU to fulfill this joint and several pledge might be tested if some other members are unwilling to honor a capital call on a pro-rata basis.
The EU’s annual budget is set according to the terms of the MFF. As part of the MFF, member states agree to commitments for individual budgetary line tems and to disbursements under these commitments. The commitments and payments are both subject to ceilings.
In particular, the amounts paid in by EU members, from taxes and levies that fund the EU’s commitments, must not exceed the MFF payment ceiling. As per an EU council regulation, these amounts paid into the EU’s “own resources” account are adjusted retrospectively to reflect the actual value-added-tax base, as well as backward revisions to GNI as and when they are determined. Our rating on the EU reflects our assumption that member states will fulfil these obligations in accordance with retrospective revisions.
Germany, France, and the U.K. contribute 21%, 16%, and 13%, respectively, of net transfers to the EU budget (2016).
OUTLOOK
The stable outlook reflects our opinion that the rounded average GDP-weighted rating on the EU’s budgetary contributors will stabilize at current levels of ‘AA’ for the next two years under most possible scenarios, including a U.K. departure from the EU. This is the case even if the ratings on the two net contributing sovereigns with negative outlooks were both lowered [France (AA/Negative/A-1+) and Finland (AA+/Negative/A-1+)]. The stable outlook also reflects our view that no other member states will leave the EU, and that the 27 remaining EU members will reaffirm their support to the EU and its key spending programs, although following a U.K. exit we expect the absolute level of spending will decline during the next MFF (2021-2027).
Rating pressure could build if the GDP-weighted average rating on net EU contributors continued to decline, or if we perceived more doubtful support from EU members for the union’s key policies.
Rating upside appears remote at this point, but could come from a combination of a higher weighted-average rating on net EU contributors or strengthened political cohesion in the block.
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