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, as well as to lend under other programs, such as the European Atomic Energy Community (EURATOM). 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+'.
- The institutional arrangements backing the EU underpin our rating on the supranational organization. In the unlikely event that borrowing member states defaulted on their loans from the EU, the EU could draw upon its budgetary resources to make payment on its own debt.
- Because the EU has no paid-in capital, our methodology puts considerable weight on the average weighted rating on net budgetary contributors to the EU.
- Germany, France, and the U.K. contribute more than 70% of net transfers to the EU budget, and excluding own resources in gross terms, these three states contribute 50% of total EU member state national contributions.
- We are revising our outlook on the EU to negative from stable and affirming the 'AA+/A-1+' ratings.
- The negative outlook reflects our view that there is a greater than one-in-three likelihood of a rating change on the EU during the next two years.
On Aug. 3, 2015, Standard & Poor's Ratings Services revised its outlook on the supranational institution, the European Union (EU), to negative from stable. The 'AA+/A-1+' long- and short-term issuer credit ratings were affirmed.
The outlook revision reflects the following:
- Our expectation that the EU will provide first-loss guarantee support for financing connected to the Juncker Plan;
- Further downward pressure on the average weighted rating on net budgetary contributors to the EU, as indicated by our negative outlooks on the second- and third-most important sovereign contributors, the U.K. and France (Germany is the largest contributor); and
- The EU's repeated use of its balance sheet to provide higher-risk financing to EU member states (most recently including Greece), without the member states' paying in capital.
Since we last reviewed our ratings on the EU on Oct. 14, 2014, we revised our outlook on the second-largest net contributor to the EU budget--the U.K.--to negative, reflecting among other concerns, the U.K. government's decision to hold a referendum to exit the EU (for further details, see "United Kingdom Outlook Revised To Negative; 'AAA/A-1+' Ratings Affirmed," published June 12, 2015, on RatingsDirect). The negative outlook on the EU also reflects its lack of any paid-in capital, a key difference compared with other multilateral institutions. The EU continues to run a very large negative net asset position, largely reflecting its considerable pension obligations. 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 (though not exclusively) to EU member states in economic difficulty with limited access to commercial bond markets. Since lowering our rating on the EU to 'AA+' on Dec. 20, 2013, we have lowered the ratings on Bulgaria, Croatia, Finland, and Greece. Over the same period we have taken positive rating actions on Cyprus, Hungary, Ireland, Latvia, Lithuania, Romania, Slovenia, and Spain. On Oct. 10, 2014, we lowered the ratings on one 'AAA' rated EU member (Finland), leaving four 'AAA' rated members (Germany, Luxemburg, Sweden, and the U.K.). Since 2007, the revenues contributed by 'AAA' rated sovereigns as a proportion of total revenues have nearly halved to 34%. At the same time, the average sovereign rating for the 11 members that are net contributors to the EU budget (NBCAR), weighted by the sum of their contribution, remains unchanged at 'AA+' since 2013. Although our positive outlooks (seven) on the EU-28 member states outnumber negative outlooks (two), the two negative outlooks are on the second- and third- largest net contributors to the EU budget, the U.K. and France, respectively. Together, France and the U.K. make up 31% of EU GDP and an estimated 39% of net EU budgetary contributions. An upgrade of The Netherlands, for instance, would not neutralize the effect of lower ratings on either the U.K. or France, given that The Netherlands accounts for only 6% of total net contributions to the budget. We acknowledge that net contributions from member states do not reflect the benefits to members' economies from EU membership, including the reduction in transaction costs and other positives from being part of the single market. Nevertheless, the 1999 European Council stipulated that operating expenditure data (which refer to "net budgetary contributions") would be considered as budgetary imbalances. Using other accounting definitions for budgetary support, the importance of France and the U.K. is somewhat lower. For example, as a share of total (gross) member states' national contributions excluding own resources, France and the U.K. account for 29% of the total. This continues to be a large share of the total, however. Moreover, under our methodology for rating multilateral lending institutions (MLIs) we do not consider these budgetary contributions to be a substitute for loss absorbing paid-in capital. 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 current payables, 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 consideration, and, alongside the entity's importance to its membership, is the cornerstone for rating the EU according to our criteria " Principles of Credit Ratings," published Feb. 16, 2011). We use our principles of credit ratings criteria to assess the EU, owing to the uniqueness of the supranational's structure, noting that it shares some characteristics with other supranational entities. 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, though 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, its high credit rating partly recognizes its preferred creditor treatment (a key rating factor for many MLIs that lend primarily to the public sector, as specified in paragraph 25 of our criteria, " Multilateral Lending Institutions And Other Supranational Institutions Ratings Methodology," published Nov. 26, 2012). 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. The EU is a treaty organization, which we view as positive for the rating under paragraph 23 of our multilateral lending and supranationals criteria. It has some characteristics in common with other supranationals, especially in its objectives and the sort of programs it funds. Unlike most financial entities, including the European Financial Stability Fund--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 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, as well as to nonmember states via its small-scale macrofinancial lending to Serbia, Bosnia, Macedonia, Albania, Armenia, and Ukraine. The EU also extends its guarantees on the European Investment Bank's (EIB's) lending to small and midsize enterprises and other loans. In January of this year, the European Commission adopted a legislative proposal for the European Fund for Strategic Investments (EFSI). The fund aims to back €315 billion (or 2.2% of EU-28 GDP) in private and public investments. It establishes a first-loss guarantee equivalent to €11 billion, with the risk assumed by the EU, should losses on investments under EFSI be incurred by the EIB or the European Investment Fund (EIF). We understand the guarantee will be irrevocable, and that the EU must pay within 20 days of a call by the EIB management. The maximum guarantee of €16 billion (including first-loss and general guarantee) will be gradually 50% cash financed into a guarantee fund, over an extended period of seven years. The funding for the EU guarantee fund will come from existing margins within the EU budget (€2 billion), as well as the redeployment of grants from the Connecting Europe Facility (€3.3 billion), and the Horizon 2020 program (€2.7 billion). Although we think EFSI investments will materialize only gradually, in synch with the increase in cash coverage of the guarantee, we note that this would significantly increase the EU's off-balance-sheet exposures over the short term, backing projects that target a higher risk profile. We see this as a marked increase in the EU's contingent liabilities. This is particularly the case because the guarantee is leveraged by the EIB and EIF exposures, therefore significantly increasing the risk for the EU. If the EFSI guarantee is called above its €8 billion budgetary allotment, the EU would find the additional resources either from existing margins within the multi-annual financial framework (MFF) ceiling (which in 2013 was the difference between own resources, representing committed revenues to the EU of 1.23% of EU gross national income (GNI), and the amount spent on actual payment appropriations in any particular year (1.06% of GNI in 2013); or, alternatively, by cutting spending on other EU programs. In other words, the guarantee call would have to be budgeted, and as in the past, the EU's budget must balance by definition. We view the ratings on the EU as closely linked to those on its member states, through the assessments in the budget and the contingent claims detailed below. As of year-end 2014, the EU's outstanding loans and guarantees totaled €84.1 billion (including EURATOM, as well as guarantees for EIB operations of an estimated €24 billion). With the addition of the EFSI exposure, this total exposures increases to about €100 billion, to gradually decrease as the €8 billion guarantee fund is being constituted. 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 is prepared and amply capitalized to provide assistance to eurozone member countries. The recent bridge financing to Greece for €7.2 billion is a three-month short-term exposure, and will not likely be replaced by additional exposure to Greece (CCC+/Stable/C). Still, we note that two member states (the U.K. and the Czech Republic) requested and received a form of guarantee from the European Central Bank that any cash call on them in the event of a default by Greece on the EFSM loan would be covered by cumulative Eurosystem profits on treasury ("Securities Market Programme") holdings on Greek government bonds. 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). Together, Ireland and Portugal represent 78% of EU loans outstanding. 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 GNI of its member states (€1,024 billion) over the 2014-2020 MFFs. 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 months, 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; as of year-end 2014, cash and cash equivalents exceeded €15 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. As a point of comparison with MLIs, and using the fiscal headroom to calculate our risk-adjusted capital ratio (our primary metric for assessing capital adequacy for MLIs), we estimate that the EU's capital adequacy is strong. 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, which was approved in early December 2013. 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. The agreement at European Council level regarding the 2014 MFF was reached in February 2013 and the regulation adopted by the European Council only in December 2013, after negotiations with the European Parliament. During these negotiations, non-eurozone members that are net contributors to the EU budget, and which are typically 'AAA' rated, argued for a reduction in budgetary payments. This relatively small but important group of EU members was able to determine at least a temporary limit to the EU's budget. Other net contributors, notably eurozone members, have continued to debate the U.K.'s rebate (a formula for the U.K.'s budgetary contribution specific to it). Further, the U.K.'s re-elected conservative government has pledged to organize a referendum on continued EU membership, set to take place in 2016.
The negative outlook reflects our view that there is a greater than one-in-three likelihood of a rating change on the EU during the next two years. We could consider a negative rating action if the sovereign creditworthiness of net contributing EU sovereigns deteriorated, if we considered future budgetary negotiations to be more protracted and acrimonious than past negotiations, if members applied to leave the EU, or if its financial measures deteriorated. We could revise our outlook on the EU to stable if we affirm the ratings on two large net contributors, the U.K. and France, at their respective current levels.
Related Criteria And Research
- Multilateral Lending Institutions And Other Supranational Institutions Ratings Methodology, Nov. 26, 2012
- Principles Of Credit Ratings, Feb. 16, 2011
- 2014 Annual Sovereign Default Study And Rating Transitions, May 18, 2015
- Supranationals Special Edition 2014, October 2014
- How An Erosion Of Preferred Creditor Treatment Could Lead To Lower Ratings On Multilateral Lending Institutions, Aug. 26, 2013
Outlook Action; Ratings Affirmed To From European Union Issuer Credit Rating Foreign Currency AA+/Negative/A-1+ AA+/Stable/A-1+ Senior Unsecured AA+ AA+
Complete ratings information is available to subscribers of RatingsDirect at www.globalcreditportal.com and at spcapitaliq.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column. Alternatively, call one of the following Standard & Poor's numbers: Client Support Europe (44) 20-7176-7176; London Press Office (44) 20-7176-3605; Paris (33) 1-4420-6708; Frankfurt (49) 69-33-999-225; Stockholm (46) 8-440-5914; or Moscow 7 (495) 783-4009.
|Primary Credit Analyst:||Frank Gill, Madrid (34) 91-788-7213;|
|Secondary Contact:||Elie Heriard Dubreuil, London (44) 20-7176-7302;|
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