Rating action

Scope Ratings GmbH (Scope) has today affirmed the Grand Duchy of Luxembourg’s (Luxembourg) long-term local and foreign currency issuer and senior unsecured debt ratings at AAA, with Stable Outlooks. The short-term issuer ratings have been affirmed at S-1+ in both local and foreign currency, with Stable Outlooks.

Scope’s affirmation of Luxembourg’s AAA ratings reflects its: i) wealthy, competitive and high value-added economy; ii) strong public finances, characterised by low debt, a good record of fiscal prudence, and a resilient public debt structure; 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. Challenges include: i) exposure to adverse external developments as a small, open economy; ii) long-term fiscal pressures linked to population ageing and generous social security systems; and iii) financial vulnerabilities linked to elevated private debt levels and an outsized financial sector.

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Key rating drivers

Wealthy, competitive and high value-added economy. 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 globally, at USD 141,400 (at purchasing power parity) in 2023. Luxembourg’s economy is characterised by high value-added activities given its status as a global financial centre, sound policymaking and strong institutions, and robust growth. Over 2015-19, real growth averaged 2.5%, the highest of among Scope’s AAA-rated sovereign peer group. The Luxembourg economy displayed broad resilience to the Covid-19 shock and experienced a forceful post-pandemic recovery, thanks to effective policy response and to the strong performance of the ICT and financial sectors.

Economic output contracted by 1.1% last year mainly due to weak exports and business investment, in line with an environment of subdued external demand and tight financing conditions. The slowdown was particularly pronounced in the financial services and construction sectors, as the shift in funding conditions led to a decline in financial sector transaction volumes and adverse asset valuation developments, while higher mortgage rates resulted in a sharp deceleration in real estate market activity. These headwinds outweighed otherwise dynamic household consumption, which benefitted from the automatic indexation of wages, decelerating inflation, generous government support measures and elevated excess savings. Scope expects real GDP growth to recover over the medium term, to 1.4% in 2024 and 2.7% in 2025. The economic momentum will benefit from robust private consumption, underpinned by high real wage growth and supportive fiscal policy, as well as from a gradual pick-up in private investment, in line with a progressive loosening of borrowing conditions and improvements in external demand.

Growth should subsequently converge to an estimated robust growth potential of 2.0-2.5% annually, anchored by solid investment dynamics. Risks to the near-to-medium term growth outlook are tilted to the downside, primarily reflecting potential negative spillovers from geopolitical tensions and a degree of uncertainty related to the implementation of the OECD-led global corporate tax deal, though Scope presently does not expect planned changes to materially impact Luxembourg’s attractiveness as a global business centre.

Robust public finances. The AAA ratings are also underpinned by Luxembourg’s strong fiscal fundamentals. The country has a historical record of consistent budget surpluses and overachieving its medium-term budgetary objectives. The fiscal surplus averaged 2% of GDP over 2015-19, reflecting very prudent fiscal management and dynamic government revenues. After dipping to a comparatively moderate 3.4% of GDP deficit in 2020, Luxembourg’s headline fiscal balance returned to a 0.5% of GDP surplus in 2021 thanks to a strong recovery in revenue and the phase-out of Covid-19 related measures.

The general government deficit widened to 1.3% of GDP in 2023, up 1 percentage point from the previous year, primarily due to spending pressures from energy support measures (total budgetary cost of 1.6% of GDP) and the revaluation of public sector wages and social transfers. Scope expects the fiscal deficit to increase further, to 1.6% and 1.9% of GDP in 2024 and 2025, respectively. Expenditure growth is forecast to remain elevated, resulting from the partial extension of energy support policies, persistent pressure from public sector wages, welfare and pension payments and the roll-out of a policy package aimed at supporting the housing sector (estimated cost of around EUR 300m over 2024-27, totalling 0.4% of 2023 GDP). At the same time, revenue growth should moderate due to the revaluation of personal income tax brackets. In addition, the government has announced plans to reduce the corporate income tax rate by 1 percentage point in 2025, which will further weigh on fiscal receipts. The general government deficit should then stabilise at around 1.5% of GDP over 2025-29. This outlook also accounts for government commitments to maintain public investments at an elevated level, at around 4.5% of GDP over coming years, as well as to raise the level of defense spending to 2.0% of gross national income over the medium-term (from 1.3% in 2024).

While this trajectory constitutes a pronounced loosening of the Luxembourg government’s fiscal stance relative to the pre-pandemic period, Scope expects the debt-to-GDP ratio to remain low relative to AAA-rated peers. It is forecast to rise to about 32% by 2029, up from 25.7% at end-2023, as robust nominal growth prospects and still-moderate interest payments partly offset the impact of widening primary deficits. Strong debt affordability is anchored by a favourable debt structure, characterised by low funding costs (average interest rate of around 1.8% in 2023), comfortable average maturity (7.6 years) and no foreign currency exposure.

Strong external position. Finally, the AAA ratings are bolstered by a strong external position. Luxembourg has consistently generated large current account surpluses, averaging 5.9% of GDP over 2015-19. Sustained current account surpluses have resulted in a large positive net international investment position of around 34% of GDP as of end-2023. The current account surplus moderated to 6.8% last year, down 0.9 percentage points from the previous year due to a moderation in services export surpluses, all the while remaining above pre-pandemic averages. Scope expects the current account balance to remain strong over the coming years and to stabilise at around 7.0% over a forecast horizon up to 2029.

Rating challenges: exposure to external developments, long-term age-related spending pressures, rising financial sector vulnerabilities.

First, as a small, very open economy (export and import sectors accounting for around 200% of GDP) with a large, globally interconnected financial sector, Luxembourg is subject to macro-economic volatility and exposed to developments in the external environment. Geopolitical tensions remain a major risk with potential large implications for supply chains and world trade. Additionally, changes in the global tax environment may weigh structurally on the country’s growth outlook and fiscal performance.

Second, Luxembourg faces substantial long-term age-related spending pressures. It is expected to register one of the largest increases in age-related expenditure (pensions, healthcare, long-term care, education) in the EU, estimated at 4.4pps of GDP between 2022 and 2050 (versus an EU aggregate of 1.1pps)¹. While demographic trends compare favourably to rating peers, this adverse trajectory primarily reflects a generous social security system, with high replacement rates and comparatively low effective retirement age (60.5 years for men and 58.4 years for women).² Scope notes that the pension system remains in a comparatively strong position, having accumulated a EUR 24.5bn financial reserve by the end of 2022 which covered more than four years of outlays.³

Finally, financial imbalances remain at an elevated level. Total banking sector assets amount to around 12 times annual GDP, which could lead to contingent liability risk for the government under severe scenarios. Residential real estate prices registered their fifth consecutive quarter of decline in Q4 2023 and stood nearly 16% below their last peak in Q3 2021 – among the sharpest falls in the euro area – amid rapidly rising mortgage rates. This correction, in a context of elevated household debt (69% of GDP at end-2023), may present a degree of risks for financial sector stability, via a weakening of lower income households’ debt servicing capacity. Still, financial sector resilience is supported by effective oversight frameworks, high household wealth and high capital and liquidity buffers, as noted in the latest IMF Financial Sector Assessment Program.⁴ As a large centre for non-bank financial intermediation, real estate funds located in Luxembourg have seen a sharp increase in their net asset value in recent years, making Luxembourg the second biggest market in Europe after Germany.⁵ While risks in the commercial real estate market could lead to a significant decline in net asset values, much of the exposures relate to cross-border investment flows, and the Luxembourg Financial Sector Supervisory Commission (CSSF) continues to actively monitor the sector.

Outlook and rating sensitivities

The Stable Outlook represents Scope’s view that risks to the ratings over the next 12 to 18 months are balanced.

Downside scenarios for the rating and Outlooks are (individually or collectively):

1. Growth outlook deteriorates substantially;
    
2. Fiscal fundamentals weaken significantly;
    
3. Vulnerabilities in the financial system threaten macro-economic stability.

Sovereign Quantitative Model (SQM) and Qualitative Scorecard (QS)

Scope’s SQM, which assesses core sovereign credit fundamentals, signals a first indicative credit rating of ‘aa+’ for Luxembourg. Under Scope’s methodology, the indicative rating receives 1) a one-notch positive adjustment from the methodological reserve-currency adjustment; and 2) no negative adjustment from the methodological political-risk quantitative adjustment. On this basis, a final SQM quantitative rating of ‘aaa’ is reviewed by the Qualitative Scorecard (QS) and can be changed by up to three notches depending on the size of Luxembourg’s qualitative credit strengths or weaknesses compared against a peer group of sovereign states.

Scope identified the following QS relative credit weaknesses for Luxembourg: 1) macro-economic stability & sustainability; 2) financial imbalances. Conversely, Scope identified the following QS relative credit strengths for Luxembourg: growth potential and outlook. On aggregate, the QS generates no adjustment for Luxembourg’s credit ratings, resulting in final AAA long-term ratings. A rating committee has discussed and confirmed these results.

Environment, social and governance (ESG) factors

Scope explicitly factors in ESG issues in its ratings process vis-à-vis the sovereign-rating methodology’s stand-alone ESG sovereign-risk pillar, which holds a significant 25% weighting under the quantitative model (SQM) and 20% weight under 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 to natural disaster risks. However, these strengths are partially offset by the high footprint of consumption relative to available biocapacity, given the physical constraints of its geography, and some of the highest greenhouse gas emissions per capita in the EU. Its energy mix is mostly made up of fossil fuels (77% of available energy in 2022), owing to large demand for transportation fuels, 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 emissions that are not covered by the European Union Emission Trading Scheme (ETS) by 50-55% versus 2005, (above the 40% reduction required by the EU). It plans net-zero greenhouse gas emissions by 2050.

As regards social risk factors, Luxembourg receives a higher score than peer countries, 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 17.3% in 2022, up from 15.9% in 2013. 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.

Finally, under governance-related factors captured by the SQM, Luxembourg holds strong scores on a composite index of five World Bank Worldwide Governance Indicators, reflecting strong democratic institutions, with no negative adjustment under the political-risk assessment. Furthermore, Scope’s Qualitative Scorecard evaluation on ‘governance factors’ indicates Luxembourg is in line with the performance of ‘aaa’ indicative-rated sovereign peers, reflecting stable political conditions and broad consensus on key policy issues, including European integration and fiscal prudence. Luc Frieden took over as Prime Minister from Xavier Bettel after the elections in October 2023, as leader of a new coalition between the Christian Social People’s Party and the Democratic Party.

Rating committee
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. European Commission - The 2024 Ageing Report
2. OECD – Pensions at a Glance 2023, Effective age of labour market exit
3. Inspection Générale de la sécurité sociale – La situation financière du régime général d'assurance pension
4. IMF - Luxembourg: Staff Concluding Statement of the 2024 Article IV Mission
5. ESMA – EU Alternative Investment Funds 2023

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Sovereign Rating Methodology, 29 January 2024), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The model used for these Credit Ratings and/or Outlooks is (Sovereign Quantitative Model Version 3.0), 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   YES
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: the Rated Entity, 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/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings and/or Outlooks were not amended before being issued.

Regulatory disclosures
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: Brian Marly, Analyst
Person responsible for approval of the Credit Ratings: Eiko Sievert, Director
The Credit Ratings/Outlooks were first released by Scope on 19 October 2018. The Credit Ratings/Outlooks were last updated on 27 January 2023.

Potential conflicts
See www.scoperatings.com under Governance & Policies/Regulatory for a list of potential conflicts of interest disclosures related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
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