Scope affirms Luxembourg's credit ratings at AAA with a Stable Outlook
Scope Ratings GmbH has today affirmed the Grand Duchy of Luxembourg’s (Luxembourg) AAA long-term issuer and senior unsecured local- and foreign-currency ratings, along with its short-term issuer rating of S-1+ in both local and foreign currency. All Outlooks remain Stable.
Summary and Outlook
Scope’s affirmation of Luxembourg’s AAA ratings reflects its: i) wealthy, competitive and high value-added economy; ii) robust public finances, characterised by low debt, a good record of consistent fiscal surpluses pre-Covid-19, and prudent fiscal management; and iii) a strong external position reflecting its significant net external creditor position. These factors contribute to Luxembourg’s economic resilience and ability to face future shocks, as demonstrated during recent crises. The rating is constrained by: i) a small, open economy that is exposed to developments in global taxation frameworks and international financial markets; ii) long-term fiscal pressures linked to population ageing and generous social security systems; and iii) rising financial vulnerabilities linked to increasing real estate prices and elevated private debt levels.
The Stable Outlook reflects Scope’s view that risks to the ratings are balanced over the next 12 to 18 months.
The rating/Outlook could be downgraded if, individually or collectively: i) Luxembourg’s economic outlook deteriorates substantially; ii) fiscal fundamentals deteriorate significantly; and/or iii) vulnerabilities in the financial system were to weigh on the country’s macro-economic stability.
Luxembourg’s AAA ratings are supported by its wealthy, competitive and high value-added economy. The country has one of the highest GDP per capita at USD 134,540 (at purchasing power parity) in the world. Luxembourg’s economy is characterised by high value-added activities given its status as a global financial center, sound policymaking and strong institutions, dynamic job creation, and robust growth. Over 2015-19, real growth averaged 2.8%, the highest of its peers after Ireland (9.9%). The country’s good economic fundamentals and its swift, forceful, and effective policy response to the Covid-19 crisis resulted in a remarkably mild recession in 2020 of only 1.8%, while quarterly real GDP had returned to its pre-crisis level by Q3 2020. The Luxembourg economy rebounded in 2021 with real growth of 6.9% over the year, thanks to the strong performance of the ICT and financial sectors as well as to government measures supporting private demand.
The economic recovery decelerated following the escalation of the Ukraine conflict and associated inflationary pressures in the beginning of 2022. Inflation has increased sharply from H2 2021 and stood at 6.2% (HICP, year-on-year) in December 2022 – having nevertheless declined significantly from June peaks of 10.3%. Subdued business sentiment, soaring producer prices and the tightening of funding conditions weighed on private investment, while soaring nominal energy imports and weaker demand from key European trading partners reduced the contribution on net exports to growth. At the same time, private consumption remained broadly resilient, thanks to the indexation of wages, government support measures as well as to the significant excess savings accumulated during the pandemic. After contracting by 0.5% (quarter-on-quarter) in Q2 2022, real GDP increased by 1.1% in the third quarter of the year. Scope forecasts still-robust growth of 2.0% in 2022 and 2.2% in 2023, before converging back to the long-term potential of 2.5%, though downside risks to the medium-term economic outlook remain.
The AAA ratings are also underpinned by Luxembourg’s robust public finances. The country has a good record of consistent budget surpluses and overachieving its medium-term budgetary objectives. The budget balance averaged 2% of GDP over the 2015-19 period, reflecting very prudent fiscal management and strong tax revenues. After dipping to a comparatively moderate 3.4% of GDP deficit in 2020, Luxembourg’s headline fiscal balance swung back to a 0.9% of GDP surplus in 2021 thanks to a strong recovery in revenue and to the phase out of Covid-19 related measures – well ahead of previous estimates and of peer countries. The fiscal outlook has deteriorated following the outbreak of the Ukraine war, owing to the roll-out of a support package amounting to EUR 2.6bn (3.3% of GDP) to be disbursed 2022-23 as well as to the revaluation of public sector wages, social transfers and pensions. At the same time, the resilience of private demand, robust employment and wage dynamics, and impact of inflation on VAT receipts should support robust revenue growth. Scope estimates the budget balance turned to a moderate deficit of 0.4% of GDP in 2022, which will widen to 2.2% of GDP in 2023, before gradually receding over subsequent years. In line with expectations of persistent, albeit moderate, primary deficits and relatively favorable growth, Scope anticipates a progressive increase in the debt-to-GDP ratio over the medium term, to stabilize at around 29.0% of GDP by 2026 – up 6.7pps above its-end 2019 level but remaining low compared to AAA-rated peers.
Luxembourg’s public finance risk profile is further strengthened by the government’s favorable debt structure, with a marginal share of short-term liabilities (7% of total), no foreign currency exposure and adequate, albeit low relative to peers, average maturity of 6.5 years. The sovereign balance sheet is further bolstered by large government financial wealth, with assets worth 78% of GDP as of Q2 2022. Funding costs have increased in recent months, in line with the tightening of monetary policy, averaging at 2.7% in December 2022 (their highest level since 2011), but remaining moderate relative to peers. These factors provide Luxembourg with ample fiscal buffers to face future shocks as well as long-term age-related fiscal pressures, a key credit strength.
Finally, the AAA ratings are bolstered by a strong external position. Luxembourg has consistently generated current account surpluses, averaging 4.8% of GDP over 2015-19. Sustained current account surpluses have resulted in a large positive net international investment position of around 31% of GDP as of June 2022. After rebounding strongly to 9.9% of GDP in the year to June 2021, the current account surplus declined to 3.1% in the year to Q3 2022, in a context of deteriorating terms of trade and weaker demand from euro area trading partners. Scope expects the current account balance to recover over coming years and to stabilize at around 4.5% on average in 2024-27.
Despite these considerable credit strengths, Luxembourg faces several credit challenges.
First, as a small, open economy with a large financial sector, Luxembourg is subject to macro-economic volatility and exposed to developments in the external environment. Changes in the global tax environment may weigh structurally on the country’s growth outlook and fiscal performance, as highlighted by the IMF1. The OECD-led global tax deal could have adverse repercussions for Luxembourg which maintains a competitive tax landscape and relies heavily on tax revenue from corporate income and gains (15% of total revenue in 2019). However, the final impact of Luxembourg’s economy and fiscal performance could be mitigated by several factors. The regulated financial sector is expected to be excluded from Pillar One of the OECD-led agreement, while Luxembourg’s effective tax rate on corporate income remains well above the Pillar Two minimum rate of 15%, at 24.9%2. In addition, Luxembourg has considerable non-tax advantages such as its status as a global financial hub with a well-established ecosystem, a skilled multilingual workforce, and a stable political and social environment.
Second, Luxembourg faces substantial long-term age-related spending pressures. It is one of the EU countries that will see the largest increase in healthcare and pensions costs due to population ageing, estimated at 4.7pps of GDP between 2020 and 2050 (versus an EU average of 1.3pps)3. Age-related fiscal pressures are slightly worse than for peers despite more favourable demographics, reflecting generous social security systems, high replacement rates, and a relatively low effective retirement age (61.3 years). Still, the generous system will contribute to retirees keeping their purchasing power, contrary to other European countries in which retirees will see a gradual erosion in their purchasing power. In addition, the pension system remains in a comfortable medium-term financial position, given ample revenues that should continue to outweigh spending at least through 2032. In addition, the pension system has accumulated a EUR 23.8bn (37.1% of GDP) financial reserve which covers almost five years of outlays. The reserve will start to erode in 2032 and will fully deplete by 2047, after which the pension deficit will start to weigh on Luxembourg’s budget deficit and debt trajectory4. The government is consulting with the Economic and Social Council, which includes private sector representatives and trade unions to explore and suggest reforms.
Finally, financial sector vulnerabilities continue to build up and could pose a risk to Luxembourg’s macro-financial stability. Growth in housing prices has accelerated in recent years owing to strong demographic and economic growth, increasing mortgage debt combined with supply-side constraints. After accelerating during the pandemic crisis, residential real estate price growth has moderated over the course of 2022, in a context of rising lending rates and decelerating mortgage lending, all the while remaining elevated. The Eurostat house price index increased by 11% in the year to September 2022, above the euro area average of 7%. The Luxembourg government has implemented a set of prudential measures aimed at tackling associated risks, including loan to value limits, more stringent risk weighting and an increase to the countercyclical capital buffer rate, although these are deemed only partially sufficient by the European Systemic Risk Board5. Additionally, household and non-financial corporate debt are elevated, amounting to about 180% of gross disposable income and 268% of GDP, respectively. Luxembourg’s large financial sector is also highly integrated in global capital markets, and thus exposed to global financial market risk. Still, financial system risks are mitigated by effective oversight frameworks, a resilient banking sector, and high, albeit unevenly distributed, household wealth.
Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)
Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides an indicative credit rating of ‘aa+’. Luxembourg receives a one-notch uplift to this indicative rating via the reserve-currency adjustment for euro-area membership under the methodology. As such, under the methodology, ‘aaa’ final indicative ratings can thereafter be adjusted by the Qualitative Scorecard (QS) by up to three notches, depending on the size of relative credit strengths or weaknesses versus peers based on analysts’ qualitative analysis.
For Luxembourg, the following relative credit strengths via the QS have been identified: i) growth potential; and ii) debt sustainability. Conversely, the following relative credit weaknesses have been identified: i) macro-economic stability and sustainability; and ii) financial imbalances.
Combined relative credit strengths and weaknesses identified in the QS result in no adjustment to the ratings and indicate a sovereign credit rating of AAA for Luxembourg.
A rating committee has discussed and confirmed these results.
Factoring of environment, social and governance (ESG)
Scope explicitly factors in ESG sustainability issues during its rating process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 25% weighting under the quantitative model (CVS) as well as in the methodology’s qualitative overlay (QS).
On the sovereign ESG pillar’s environmental risk sub-category, Luxembourg’s quantitative scores are strong in terms of the CO2 intensity of its economy (as measured by emissions per unit of GDP) and as regards natural risks. However, its large deficits of the footprint of consumption relative to available biocapacity, given the physical constraints of its geography, result in a weak score for resource risks. Additionally, Luxembourg has some of the highest greenhouse gas emissions per capita in the EU, generating 0.34% of the EU’s total greenhouse gas emissions despite only accounting for 0.14% of total EU population. Its energy mix is mostly made up of fossil fuels (85% of total primary energy supply in 2021), with one of the lowest shares of renewable energy among EU countries. It is also highly dependent on resource imports given its small, natural resource poor territory. The government has adopted ambitious energy sector targets for 2030 to reduce non-ETS emissions by 50-55% versus 2005, (above the 40% reduction required by the EU). It plans net-zero greenhouse gas emissions and 100% renewable electricity by 2050. The country has adopted measures that will help reach its emissions target, including the introduction of a carbon tax in January 2021 which was increased in 2022 to EUR 25 per ton and will increase further over the medium term.
As regards social-risk factors, Luxembourg scores higher than similarly-rated peers within Scope’s, reflecting more favourable ageing-dynamics and similarly strong marks with regards to income inequality and labour force productivity. Social outcomes are strong in an EU context although poverty levels and income inequality have worsened over the past decade. The proportion of people at risk of poverty stood at 18.1% in 2021, up from 13.6% in 2011. While Luxembourg benefits from more favourable demographic dynamics than European peers, the generosity of its social systems could come under strain in the context of population ageing. The EU commission expects the cost of population ageing to grow by about 6.3pps of GDP over 2019-50, one of the largest increases among EU-peers3.
Finally, under governance-related factors captured in Scope’s Core Variable Scorecard (quantitative model), Luxembourg holds strong scores on a composite index of six World Bank Worldwide Governance Indicators, reflecting strong democratic institutions. Furthermore, Scope’s Qualitative Scorecard evaluation on ‘governance factors’ indicates Luxembourg is in line with performance of ‘aaa’ indicative sovereign peers, reflecting stable political conditions and broad consensus on key policy issues, including European integration. Xavier Bettel has been prime minister since 2013 and was confirmed after the 2018 elections, with support from a coalition formed by his party (the Democrats), the Socialist Party and the Greens. The next elections are scheduled for 2023.
For the updated report, click here.
The main points discussed by the rating committee were: i) recent economic and fiscal developments, ii) medium-term economic outlook; iii) real estate market dynamics and banking sector resilience; iv) debt trajectory and contingent liabilities; v) election outlook; and vi) peer comparisons.
Rating driver references
1. IMF - Luxembourg: 2022 Article IV Report
2. PWC – Worldwide Tax Summaries, Luxembourg
3. European Commission - The 2021 Ageing Report
4. Inspection Générale de la sécurité sociale – Bilan technique du régime d’assurance pension 2022
5. European Systemic Risk Board - Vulnerabilities in the residential real estate sectors of the EEA countries
The methodology used for these Credit Ratings and/or Outlooks, (Sovereign Rating Methodology, 27 September 2022), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The model used for this Credit Rating and Outlook is the Core Variable Scorecard (verson 2.1), available in Scope Ratings’ list of models, published under https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.
Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With Rated Entity or Related Third Party participation NO
With access to internal documents NO
With access to management NO
The following substantially material sources of information were used to prepare the Credit Ratings: public domain
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Thibault Vasse, Associate Director
Person responsible for approval of the Credit Ratings: Alvise Lennkh-Yunus, Executive Director
The Credit Ratings/Outlook were first released by Scope Ratings on 19 October 2018. The Credit Ratings/Outlooks were last updated on 18 March 2022.
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.
Conditions of use / exclusion of liability
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