Scope Ratings GmbH has today affirmed the European Union’s and Euratom’s AAA long-term issuer and senior unsecured foreign-currency ratings, along with a short-term issuer rating of S-1+ in foreign currency. All Outlooks are Stable.

For the detailed rating report, click here.

Summary and Outlook

Scope’s affirmation of the AAA ratings of the European Union (EU) and the European Atomic Energy Community (Euratom) reflect the supranationals’ highly rated key shareholders, strong institutional setup ensuring de facto joint and several support, legally enshrined debt service priority combined with significant budgetary flexibility, and conservative cash management resulting in high liquidity buffers. The EU’s policy response to the Covid-19 shock will increase its outstanding liabilities almost twentyfold over the coming years to fund its SURE and Next Generation EU (NGEU) programmes¹. While this will transform the EU into the world’s largest supranational issuer of a safe asset, it will also mean that the EU will expand its traditional activities of debt-financed back-to-back lending by financing non-repayables, i.e. grants under NGEU, on capital markets, and, in addition, face higher debt repayments going forward. The EU is also exposed to the risk that its guarantees on the external and riskier activities of the European Investment Bank (EIB) and the European Fund for Sustainable Development, and, going forward, the InvestEU programme will be drawn upon. Finally, following Brexit and negotiations on rebates, the budgetary contributions based on the gross national income (GNI) of EU member states are now concentrated on fewer highly rated shareholders.

The Stable Outlook reflects Scope’s assessment of the EU’s inherent financial buffers to withstand external and balance sheet-driven shocks. The rating could be downgraded if: i) highly rated key shareholders are downgraded; ii) the institutional setup changes, resulting in a notably weaker support framework; iii) the EU’s liquidity buffers were significantly reduced; and/or iv) highly rated shareholders reduce their ultimate financial liability to the budget via additional and permanently higher rebates.

Rating rationale

The EU’s AAA rating is supported by its highly rated shareholders. Specifically, the EU’s borrowings are backed by the EU budget, which is mostly financed by GNI-based transfers from EU member states. The four largest European economies – Germany (AAA/Stable), France (AA/Stable), Italy (BBB+/Negative) and Spain (A-/Negative) – alongside Poland (A+/Stable) and Belgium (AA/Negative) provide around 75% of the EU’s GNI-based national budgetary transfers and thus constitute the EU’s key shareholders, with a weighted-average rating of AA-^a Scope notes that if Italy, Spain and Belgium were to be all downgraded by one notch, as indicated by their Negative Outlooks, the key shareholder rating would not change.

From this starting point, the EU’s AAA rating is further underpinned by its very strong institutional setup. Scope highlights that the EU's debt service ability benefits from multiple layers of protection: First, debt repayments are usually met using the proceeds of repayments from borrowing countries that received back-to-back financing of loans. This first layer of protection will continue to apply to loans provided under the SURE instrument (programme to support unemployment risks in an emergency; EUR 87.8bn of loans approved for 17 member states to date) and the NGEU recovery fund. This layer of protection will not, however, apply to grants provided under the NGEU programme, which can amount up to EUR 390bn (in 2018 prices).

However, in case a borrowing country fails to repay its loan to the EU on time, or, in the case of the bonds raised to provide direct grants to member states via NGEU, “the European Parliament, the [European] Council and the [European] Commission shall ensure that the financial means are made available to allow the [European] Union to fulfil its legal obligations in respect of third parties”². Scope acknowledges this legal debt service priority to third parties with a one-notch positive adjustment, taking into account the actual budgetary flexibility of the European Commission to delay significant amounts of the EU’s annual expenditure of about EUR 60bn-40bn from the European structural and investment funds.

Moreover, in case the EU's available cash resources were to be insufficient to cover debt service payments, the European Commission has the legal right to draw funds from all member states. In such an adverse event, the additional funds “shall be divided among the Member States, as far as possible, in proportion to the estimated budget revenue from each of them”³. Specifically, member states are legally obliged to “execute the Commission's payment orders following the Commission's instructions and within not more than three working days of receipt”⁴. In Scope’s opinion, this is an exceptionally strong and timely guarantee mechanism, with a de facto joint and several support framework that is unique among supranationals and which Scope assesses positively with an additional one-notch adjustment. These considerations, together with a track record of benefiting from preferred creditor status, provide the EU with a very strong institutional setup.

The AAA ratings also reflect the EU’s conservative liquidity management and budgetary practices, which take into account that most expenditures take place during the first quarter of each year, while debt redemptions usually follow thereafter and at the beginning of each month when cash balances are highest. Scope notes the EU's very high cash balances throughout the year. During 2020, the average cash balance until October was EUR 19.6bn while the lowest was recorded in March at EUR 12.3bn. As of October 2020, the cash balance increased again to EUR 19.6bn. Scope notes that over the past five years the cash balance has never dropped below EUR 10bn, and over the past 10 years, the lowest balance recorded was in June 2010 at EUR 6.2bn.

In addition to the cash balance, Scope also includes the budgetary margin into its calculation of the EU’s liquid assets. This refers to the difference between the maximum resources the EU can draw on from its member states without the need for any subsequent decision by national authorities, the so-called ‘own resources ceiling’, and the annual payment appropriations for the EU expenditure. While the own resources ceiling is legally binding, it has never been used. Thus, Scope has conservatively adjusted this margin for the pro-rata budgetary contributions of member states rated AA- or above, currently at 61%.

Critically, member states decided to increase the own resources ceiling from 1.20% of the EU's estimated GNI to 1.40% to account for Brexit, and for potential sudden drops of the economy, such as the one observed with the COVID-19 pandemic in 2020. In addition, member states agreed that further 0.6pp will be earmarked until 2058 specifically to cover repayment of all liabilities from NGEU borrowings. The total ceiling is thus 2.00% of the EU’s GNI. Conversely, from an expenditure point of view, Scope notes that total payment appropriations, that is, actual authorised disbursements in a given year on the EU’s seven policy areas, may not exceed EUR 171m, on average, per year. Based on available economic forecasts this is equivalent to 1.22% of the EU’s GNI for 2021. However, with the recovery and normal economic activity resuming, it is expected that the EU’s GNI will grow in the next seven years. Scope assumes conservatively annual nominal growth of 1.5% of the EU’s GNI after 2021, which results in an estimated range for payment appropriations of around 1.15% to 1.20% of the EU’s GNI.

On this basis, the margin between the potential maximum member state contribution of the EU’s highly rated shareholders and the actual payments for the 2021-27 period – adjusted for the share of member states rated AA- or above – is approximately 0.51% of the EU’s GNI. For 2021, Scope estimates this value at around EUR 69.2bn, which, together with an estimated average cash balance of EUR 24.7bn^b, results in liquid assets of around EUR 94bn for 2021.

Conversely, on the basis of 2017-19 data, Scope estimates the EU’s liabilities maturing within 12 months, excluding annual bond repayments, at around EUR 33bn (2019: EUR 27.4bn). In addition, Scope estimates that over the coming years the EU’s disbursements will increase substantially from less than EUR 5bn over the past few years to well above EUR 150bn each year during the 2021-24 period, on account of the SURE and NGEU instruments. While precise disbursements are unknown at this stage and subject to member state recovery plans and loan requests, Scope assumes, conservatively, that the full envelope for NGEU funding of around EUR 811bn will be used during 2021-26.

On this basis, Scope estimates the liquid assets ratio to drop to around 48% for the 2021-24 years from around 100% in previous years. Critically, once these large disbursements are completed, the liquidity ratio will again increase gradually to around 100% by 2027, assuming no additional significant disbursements are made for other financial assistance programmes. A ratio of 100% (50%) implies that all outstanding liabilities and all committed disbursements due within a year can be financed with available liquid assets for more than 12 (six) months without the need to access capital markets.

Looking further ahead, from 2028 onwards, the EU will have to gradually repay its outstanding liabilities. Scope estimates that the maximum annual liabilities due within one year resulting from bond repayments are likely to hover around EUR 42bn. This assumes, conservatively, that the EU repays each year the maximum amounts of EUR 10bn under SURE and EUR 29.25bn under NGEU. Actual figures are likely to be lower, however. Still, on this basis, and assuming that i) the other liabilities (mostly payables due by the EU) remain constant at around EUR 33bn (i.e. the average for 2017-19); and ii) no significant disbursements are made from 2028 onwards, liabilities due within 12 months are likely to be around EUR 78bn. This amount would be fully covered by the EU’s liquid assets, given its high cash balances and particularly given that the own resources ceiling will remain elevated at 2.00% of the EU’s GNI until all bond repayments for the NGEU programme are made.

In Scope’s view, the high liquidity buffer, comprising the cash balances and potential resources the EU can draw from member states without requiring additional decision-making processes, is essential to allow the EU to increase its issuances and disbursements in line with its mandate, which is to provide loans and grants to its member states during the most financially distressed times at very favourable terms. Scope also notes that the EU’s issuances benefit from preferential regulatory treatment as they are i) designated as Level 1 HQLA assets, ii) assigned a 0% risk weighting under the Basel framework, and iii) eligible for the European Central Bank’s asset purchase programmes, and in addition, also appeal to ESG-investors in the case of SURE bonds which are classified as social bonds under an ICMA-compliant Social Bond Framework⁵. This was highlighted in the EU’s most recent bond issuances for SURE in October 2020, which were over-subscribed more than 13x, resulting in very low funding costs of around -0.24% for the 10-year bond and 0.13% for the 20-year bond⁶.

Despite these credit strengths, the EU also faces the following credit challenges:

First, in line with its mandate, the EU’s total borrowings are expected to increase almost twentyfold due to the recently agreed SURE and NGEU programmes, to just under EUR 1trn by 2026 from around EUR 52bn as of December 2019. While this will solidify the EU’s position as the world’s largest supranational issuer, strengthen its ambition to create an EU safe asset, and provide member states with a targeted, timely and temporary counter-cyclical fiscal stimulus to facilitate the economic recovery from the Covid-19 shock, it will also imply that future EU budgets will need to earmark significantly higher annual debt repayments and redemptions.

Second, the withdrawal of the United Kingdom from the EU has resulted in a higher dependence on any one shareholder’s ability to provide EU budgetary contributions. Scope notes that 11 of the EU’s 27 shareholders are rated AA- or above, constituting around 61% of the EU’s total budgetary contributions, down from 67% previously. In addition, the budgetary shares for each of the EU’s highly rated shareholders have increased, resulting in the EU relying on fewer shareholders rated AA- or above. This has weakened Scope’s assessment regarding the concentration of EU shareholders rated AA- or above. Still, Scope acknowledges that this assessment is conservative, given the EU’s track record of receiving budgetary contributions from all member states, not just those rated AA- or above.

Third, the EU’s ultimate credit risk also includes guarantees provided to i) the EIB; ii) the European Fund for Sustainable Development, with guarantees totalling EUR 1.5bn; and, going forward, iii) the InvestEU programme, with guarantees estimated at around EUR 20bn. Guarantees to the EIB relate to its activities i) outside of the EU, with a guarantee ceiling of EUR 37.3bn as of 2019, which covers, in particular, the meaningful exposure to Turkey (B+/Stable) of EUR 8.5bn; and ii) classified under the European Fund for Strategic Investments (EFSI), with a guarantee ceiling of EUR 26bn on the EIB’s related investments, which are, on average, riskier than the traditional risk profile of the EIB’s portfolio.

Scope highlights that the overall size of guarantees has increased substantially since 2015 to around EUR 64bn at end-2019, on account of the EFSI, and will continue to rise over the coming years and likely reach around EUR 85bn, mostly driven by the InvestEU programme. At the same time, Scope notes that the risk borne by the EU budget is significantly curtailed by the assets of the related guarantee funds. Specifically, as of end-2019, the Guarantee Fund for External Actions had assets of EUR 2.8bn, the EFSI Guarantee Fund had EUR 6.7bn, the EFSD guarantee fund had EUR 599.6m, and InvestEU will provision for EUR 8.4bn (in 2018 prices). These assets result in a high provisioning rate for the comparatively new programmes, which would absorb any losses before resources would need to be drawn from the EU budget. In addition, Scope notes positively i) the track record of very low annual default payments, which to date have never exceeded EUR 110m in a given year; and ii) the EU’s conservative financial management, including ample liquidity buffers and upfront provisioning of the guarantee funds.

Finally, Scope notes that the European Council negotiations for the 2021-2027 Multiannual Financial Framework also resulted in material annual rebates for the GNI-based contributions of highly rated EU member states. While Scope acknowledges the complexity of striking a political compromise on a seven-year budgetary horizon, the rebates result in an increased share of budgetary contributions by member states with lower creditworthiness, which weakens the EU’s ability to honour debt obligations. Thus, even though the agreement is a critical sign of member states’ solidarity, underpinning the EU’s ultimate purpose and providing important political stability and budgetary predictability going forward, Scope will monitor closely the size and recipients of budgetary rebates and their implications for the financial backing of the EU budget. This is most likely to become relevant for the next Multiannual Financial Framework negotiations from 2027 onwards.

Factoring of Environment, Social and Governance (ESG)

Scope considers ESG sustainability issues during the rating process as reflected in its supranational methodology. Scope’s ‘fundamental rating’ of ‘AAA’ for both the European Union and Euratom implicitly captures governance-related factors. Environmental factors were considered during the rating process, including the risk to ‘stranded assets’ and the benefits from issuing green and/or social bonds, but did not have an impact on this rating action. Scope notes positively that issuances under the SURE programme are classified as social bonds under an ICMA-compliant Social Bond Framework and that the European Commission’s aim is to raise 30% of NGEU funds under its forthcoming Green Bonds Framework.

Scope’s supranational scorecard

Scope’s supranational scorecard, which is based on clearly defined quantitative parameters, provides an indicative ‘AAA’ rating for the European Union and Euratom. Additional considerations allow Scope to incorporate idiosyncratic characteristics that cannot be assessed in a consistent and comprehensive manner across all supranationals, but which may still affect the creditworthiness of the issuer.

For the European Union and Euratom, the following additional considerations have been identified: i) debt service priority combined with significant budgetary flexibility; and ii) an exceptionally strong and timely guarantee mechanism with a de facto joint and several support framework. Scope has acknowledged each factor with a one-notch positive adjustment.

A rating committee has discussed and confirmed these results. 

For further details, please see Appendix I of the rating report.

a) This calculation takes into account i) that the United Kingdom will not provide budgetary contributions for liabilities and obligations taken after 2021; and ii) the rebates for GNI-based contributions agreed at the European Council 17-21 July meeting.
b) This estimate is based on the average cash balance for the 2017-19 period.

Rating committee
The main points discussed were: i) key shareholders and institutional setup; ii) preferred creditor status and mandated activities; iii) joint and several support mechanism; iv) debt payment priority; v) liquidity management and buffers; vi) contingent liabilities; vii) asset quality; and viii) consideration of peers.

Rating driver references
1. European Council Conclusions July 2020
2. Treaty on the Functioning of the European Union. Article 323
3. Article 14 (4) of the Council Regulation (EU, Euratom) No. 609/2014
4. Article 15 (1) of the Council Regulation (EU, Euratom) No. 609/2014
5. EU SURE Social Bond Framework
6. EU press release 20 October 2020 on EUR 17bn dual tranche bond issuance

Methodology
The methodology applicable for this rating and/or rating outlook, ‘Supranational Entities’ 4 November 2019, is available on https://www.scoperatings.com/#!methodology/list.
Information on the meaning of each rating category, including definitions of default and recoveries can be viewed in the “Rating Definitions - Credit Ratings and Ancillary Services” published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please 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’s definitions of default and rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how Environmental, Social or Governance factors (ESG factor) are incorporated into the rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.
The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months.

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

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0.
Rating prepared by: Alvise Lennkh, Executive Director
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director
The ratings/outlook were first released by Scope on 1 February 2019.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
© 2020 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstraße 5 D-10785 Berlin.
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