Editor’s note: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’.)
- 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+’.
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.
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
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
items 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).
he 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 cohension in the block.
The full analysis is available here.