DBRS Confirms Grand Duchy of Luxembourg at AAA, Stable Trend

DBRS Ratings Limited (DBRS) confirmed the Grand Duchy of Luxembourg’s Long-Term Foreign and Local Currency – Issuer Ratings at AAA. At the same time, DBRS 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’s view that Luxembourg has significant capacity to face adverse shocks. Despite its exposure to global financial market volatility, the country’s economic prospects remain robust. Economic growth is projected at 2.6%-2.7% in 2019, outpacing that of the Euro area. The fiscal surplus might be lower in 2019, reflecting the new government’s economic programme, but the surplus is expected to increase next year, and government debt is set to decline further. House prices continue to rise, but risks to financial stability appear contained, with the banking sector in a sound financial position.

The rating reflects Luxembourg’s sound public finances and fiscal flexibility, its solid institutions and stable political environment, its advanced and very wealthy economy, and its strong external position. These credit strengths offset the challenges associated with the country’s relatively limited degree of economic diversification, its vulnerability to external shocks, rising household debt and potential medium-term pressures in the residential real estate market.

RATING DRIVERS

Given Luxembourg’s strong fundamentals, DBRS sees downward pressure on the ratings as unlikely. Nevertheless, downward pressure could stem from a severe shock to Luxembourg’s large international financial centre, most likely generated by sustained turmoil in financial markets. Downward pressure could also come from material damage to Luxembourg’s attractiveness for investment. Either of these scenarios could have a significant impact on the economy and public finances.

RATING RATIONALE

The Prospects of Luxembourg’s Wealthy Economy Are Favourable

Luxembourg’s economy is performing steadily. Real GDP growth in 2018 came in at 2.6%, mainly driven by strong private consumption boosted by wage indexation, lower personal taxation and favourable labour market conditions. Annual employment growth remains close to 4.0%, and the unemployment rate remains low at 5.5% in July 2019. In 2019, growth is projected to remain at 2.6%-2.7%, still driven by domestic demand.

On upside risks to the economic outlook, Luxembourg could continue to benefit from the relocation of financial firms from the United Kingdom to the Grand Duchy as a result of Brexit, and from potential further easing in monetary policy. Conversely, downside risks to the outlook could emerge from severe volatility in stock markets that could result from a global reassessment of financial risks or sharp changes in monetary policy. A global reassessment of risks could stem from higher global trade tensions and a no-deal Brexit. These scenarios could weigh on economic sentiment and result in reallocations of investment portfolios globally, which could have an impact on investment funds – an important driver of gross value added of the financial sector.

The performance of the financial sector is a major growth driver for Luxembourg. Its investment fund industry, the second largest in the world after the United States, has benefitted from the rise in financial assets globally, partly boosted by the quantitative easing programmes of major central banks since 2010. At the same time, policy efforts to diversify Luxembourg’s small and open economy away from the financial sector to other high-value added industries are ongoing. The financial sector accounts for 26% of gross value added, 47% of exports and 18% of budget revenues.

Luxembourg is an attractive investment destination and is among the wealthiest economies in the world. Its attractiveness as a global financial centre and as a domicile for multinational firms rests on its highly skilled workforce, competitive tax and legal frameworks, and political stability. Although the large international financial sector makes economic output volatile, Luxembourg’s exceptionally high GNI per capita – almost twice that of the Euro area average – and with the highest saving rate in Europe provide the country with significant buffers against shocks.

Risks to Financial Stability Are Contained

Parts of Luxembourg’s financial sector are interconnected, with banks and investment funds showing interconnectedness at the cross-border level. This may suggest that severe and sustained negative developments in the investment fund industry could potentially have an impact on parts of the financial sector. Nevertheless, funds have a wide range of liquidity management tools available, and the risk from large but unusual fund redemptions to custodian banks is mitigated by the sizeable stock of liquid assets held by these banks. Moreover, domestically-oriented banks have limited links to the investment fund sector. Banks are also profitable and well capitalised, their liquidity positions are comfortable, and their asset quality is good. Domestically-oriented banks, however, are exposed to the domestic housing market, as mortgage lending is concentrated in five banks.

Pressures in the housing market and the household sector could build up over time. House prices have risen by 56% since 2010. In 2018, prices increased by 7% compared to the previous year. Demand for housing is strong while supply is limited. Rising prices are affecting housing affordability. Moreover, the IMF, the European Systemic Risk Board (ESRB) and Banque centrale du Luxembourg (BCL) have identified some degree of overvaluation in the housing market.

High house prices have contributed to the rise in household debt in recent years. This debt has reached a high level of 172% of disposable income, largely in the form of mortgages. Moreover, almost 70% of the total stock of mortgages is at variable rates, exposing these mortgage borrowers to increases in interest rates. Some households could also be exposed to income shocks. Nevertheless, new mortgages are increasingly fixed-rate, and the aggregate household net worth position is relatively high at close to 440% of net disposable income. The Commission de Surveillance du Secteur Financier (CSSF) also activated the countercyclical capital buffer rate at 0.25% of risk-weighted assets, effective from January 2020. Furthermore, a draft law on the borrower-based macroprudential tools is currently in parliament.

The Political Environment Is Stable, The Budget Position Sound and Public Debt Low

Luxembourg’s political environment is stable, and its level of institutional capacity is high, with governance indicators above the average of OECD countries. As planned, the general election was held in October 2018, with no single political party obtaining an absolute majority in the Chamber of Deputies. Following government formation talks, the liberal Democratic Party, the Socialist Workers' Party and the Green Party signed a coalition agreement in December 2018, allowing Prime Minister Xavier Bettel to be reappointed and his centrist coalition to stay in power.

Broad consensus among political parties over sound macroeconomic policies provide the country with policy predictability. The new government aims to maintain Luxembourg’s attractiveness for investment, improve social cohesion, support digital transformation, progress with the economic diversification strategy, foster sustainable finance, and address housing affordability. On fiscal policy, the government remains committed to two main pillars of Luxembourg’s strong fiscal framework – complying with its medium-term objective (MTO) and maintaining the public debt ratio below its 30% of GDP ceiling. Moreover, the government has raised its MTO for the structural balance from -0.5% to +0.5% from 2020 to 2022.

As the government’s economic programme is implemented, the budget is turning slightly expansionary in 2019. The government has lowered the corporate income tax rate and broadened the bracket to which the reduced rate is applied, and has also increased energy taxes, among other measures. Public investment remains at high levels too. The government is also aiming at the simplification of the personal tax regime over the next years. In its Stability Programme, the government is forecasting a fiscal surplus of 1.0% of GDP in 2019, although the budget execution for the first half of the year points to a potentially higher surplus. The surplus is projected to improve over the medium term.

Risks to the fiscal outlook are largely related to excessive volatility in the financial sector and significantly weaker-than-expected economic growth. In the longer term, risks could also stem from major changes in tax policies in Europe and the US, EU-wide probes under state aid rules into past tax rulings, and digital taxation. The government remains committed to tax transparency initiatives and it is implementing the Anti-Tax Avoidance Directives (ATAD) I and II. Tax-related policy changes could add some degree of uncertainty to the country’s corporate tax revenues, given the presence of large multinational companies in the country. Luxembourg, nevertheless, is still expected to remain an attractive destination for investment.

General government debt remains low. Although the debt ratio almost doubled during the global financial crisis, as the state provided support to some financial institutions, the debt ratio has declined from a peak of 23.7% of GDP in 2013 to 21.4% in 2018. This is the second lowest ratio in Europe. The government is projecting the ratio to fall to 17.3% by 2023. On a net basis, the public sector has a creditor position of around 43.5% of GDP, reflecting assets of the general pension insurance scheme, assets of the Intergenerational Sovereign Wealth Fund, and equity stakes in several commercial and non-commercial companies.

The External Position Is Solid and Influenced by The Financial Sector

Luxembourg’s external position is strong, reflecting persistent current account surpluses and a large net external asset position. Although the current account surplus has been declining since 2007, it remains large, close to 5% of GDP. The surplus is driven by sizeable net exports of financial services. The country also remains a net external creditor. While the net international investment position (IIP) can be volatile, it has averaged 37% of GDP since 2010. Higher net FDI and ample liquidity in international markets have bolstered Luxembourg’s external creditor position. The net IIP is mainly accounted for by the large net external asset position of the financial sector.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the AAA – AA (high) range. The main points discussed during the Rating Committee include economic growth and prospects, fiscal policy, the financial system, the housing market and household debt.

KEY INDICATORS

Fiscal Balance (% GDP): 2.4 (2018); 1.4 (2019F); 1.3 (2020F)
Gross Debt (% GDP): 21.4 (2018); 20.3 (2019F); 20.0 (2020F)
Nominal GDP (EUR billions): 58.9 (2018); 61.3 (2019F); 64.8 (2020F)
GDP per Capita (EUR): 96,667 (2018); 96,097 (2019F); 101,652 (2020F)
Real GDP growth (%): 2.6 (2018); 2.6 (2019F); 3.1 (2020F)
Consumer Price Inflation (%): 2.0 (2018); 1.9 (2019F); 1.6 (2020F)
Domestic Credit (% GDP): 450.2 (2018); 440.4 (Q1 2019)
Current Account (% GDP): 4.7 (2018); 4.6 (2019F); 4.7 (2020F)
International Investment Position (% GDP): 45.6 (2018); 42.4 (Q1 2019)
Gross External Debt (% GDP): 6,129 (2018); 6,273 (Q1 2019)
Governance Indicator (percentile rank): 95.0 (2016); 95.3 (2017)
Human Development Index: 0.9 (2016); 0.9 (2017)

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in euro (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Fiscal balance (Statec/BcL), Gross debt (Statec/BcL), Nominal GDP (Statec), GDP per Capita (Statec/European Commission), Real GDP Growth (Statec/BcL), Inflation (Statec/BcL), Domestic Credit (BcL), Current Account (BcL/European Commission), International Investment Position (BcL), Gross External Debt (BcL). Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include Luxembourg Ministry of Finance, Trésorerie de l'Etat, National Institute of Statistics and Economic Studies of the Grand Duchy of Luxembourg (STATEC), Banque centrale du Luxembourg (BcL), Commission de Surveillance du Secteur Financier (CSSF), Luxembourg for Finance, Eurostat, European Commission, European Central Bank (ECB), OECD, IMF, World Bank, UNDP, Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party.

DBRS 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.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS’s outlooks and ratings are under regular surveillance.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (“ESMA”) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings Limited are subject to EU and US regulations only.

Lead Analyst: Adriana Alvarado, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global Financial Institutions Group and Sovereign Ratings
Initial Rating Date: December 16, 2016
Last Rating Date: March 8, 2019

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