Full text: Moody’s maintains the European Union’s Aaa rating, changes outlook to negative
Editor’s note: Moody’s issued the following press statement yesterday relating to its downgrade of the European Union’s ratings outlook.
Moody’s Investors Service has today changed to negative from stable its outlook on the Aaa long-term issuer rating of the European Union (EU). The rating agency has also changed to negative from stable its outlook on the provisional (P)Aaa rating of the EU’s medium-term note (MTN) programme.
A provisional rating for a debt facility is an indication of the rating Moody’s would likely assign to future draw-downs from the facility, pending the receipt of documentation detailing the terms of the debt issuance. Moody’s policy is to assign provisional ratings to all MTN programmes.
The outlook change to negative reflects the negative outlooks now assigned to the Aaa sovereign ratings of key contributors to the EU budget: Germany, France, the UK and the Netherlands, which together account for around 45% of the EU’s budget revenue. Moody’s believes that it is reasonable to assume that the EU’s creditworthiness should move in line with the creditworthiness of its strongest key member states considering the significant linkages between member states and the EU, and the likelihood that the large Aaa-rated member states would likely not prioritise their commitment to backstop the EU debt obligations over servicing their own debt obligations. On 23 July 2012, Moody’s had changed to negative its outlooks for the Aaa ratings of Germany and the Netherlands.
The Aaa long-term issuer rating, the provisional (P)Aaa long-term rating and the provisional (P)Prime-1 short-term issuer rating for the EU’s debt issuance programmes as well as the Aaa-ratings on existing EU issuances remain unchanged. This is because Moody’s two key rationales for assigning a Aaa to the EU remain in place, namely : 1) the EU’s conservative budget management, and 2) the creditworthiness and support provided by its 27 member states.
The European Commission is empowered to borrow on behalf of the EU, which issues debt to lend to borrowing countries under the European Financial Stabilisation Mechanism, the Balance of Payments Assistance and the Macro Financial Assistance. The EU is also a guarantor for certain external lending by the European Investment Bank (EIB, Aaa stable).
In a related rating action, Moody’s also changed to negative from stable its outlook on the Aaa long-term issuer rating and the provisional (P)Aaa MTN programme rating of the European Atomic Energy Community (Euratom), on whose behalf the European Commission is also empowered to borrow. Euratom’s key credit characteristics are identical to the EU’s, particularly the backing by the EU’s budgetary resources and by the European Commission’s right to call for additional resources from member states if needed. Hence, Euratom’s ratings tend to move in line with the EU’s.
Many of the considerations driving the change to the EU’s rating outlook — in particular the weakening of the creditworthiness of key Aaa-rated member states — are also relevant to the credit standing of other European supranational debt-issuing entities, such as the EIB, the European Investment Fund (Aaa stable), the Council of Europe Development Bank (Aaa stable) and the European Bank for Reconstruction and Development (Aaa stable). However, these entities are Multilateral Development Banks (MDBs) with significant amounts of paid-in capital, accumulated reserves, and highly diversified credit portfolios, which differentiates them from the EU. Following today’s rating action on the EU and Euratom, Moody’s will assess to what extent the credit-enhancing features of MDBs are sufficient to mitigate the impact of the weakening of the creditworthiness of key Aaa-rated member states on those MDBs’ credit standing.
RATIONALE FOR NEGATIVE OUTLOOK
The negative outlook on the EU’s long-term ratings reflects the negative outlook on the Aaa ratings of the member states with large contributions to the EU budget: Germany, France, the UK and the Netherlands, which together account for around 45% of the EU’s budget revenue. The creditworthiness of these member states is highly correlated, as they are all exposed, albeit to varying degrees, to the euro area debt crisis.
Moody’s believes that it is reasonable to assume the same probability of default by the EU on its debt obligations as the highest rated key members states’ probability of default. Whereas Moody’s acknowledges that there are structural features in place that enhance the EU’s creditworthiness, they are in Moody’s view not sufficient to delink the EU’s ratings from the ratings of its strongest key member states. In particular, in the event of a scenario of extreme stress in which Aaa-rated member states would default on their debt obligations, 1) defaults on the loans that back the EU debt would be highly likely, 2) the EU’s cash reserve would likely be stressed, and 3) the EU member states would likely not prioritise their commitment to backstop the EU debt obligations over the service of their own debt obligations. Hence, it is reasonable to assume that the EU’s creditworthiness should move in line with the creditworthiness of its strongest key member states.
RATIONALE FOR UNCHANGED Aaa/(P)Aaa/(P)P-1 RATINGS
Moody’s has left the EU’s Aaa/(P)Aaa/(P)P-1 ratings unchanged because the key rationales supporting the EU’s creditworthiness remain in place: 1) the EU’s conservative budget management, and 2) the creditworthiness and support its 27 member states provide. Four of the six largest EU countries by contribution to the EU budget have Aaa ratings: Germany, France, the UK and the Netherlands. Italy’s rating is Baa2 negative. Spain’s is Baa3, on review for possible downgrade.
Hence, debt issued by the European Union is backed by multiple layers of debt-service protection: 1) the borrowing country’s promise to repay its loan (the funds raised are lent back to back, and the borrowing country pays down the interest and loan principal; 2) the EU’s budgetary resources; and 3) the European Commission’s right to call for additional resources from member states, if needed.
The EU’s conservative budget management is based on the EU Treaty, which requires the European Union to balance the EU budget, prohibiting any borrowing to cover budgetary shortfalls. In addition, the EU’s Multiannual Financial Framework (MFF) provides the general framework for a seven-year period and establishes a ceiling for total expenditures for the annual budgets during that period.
Moreover, the EU may defer budget expenditures to accommodate its debt service. The maturing debt of both the EU and Euratom will amount to approximately EUR1.2 billion in 2012, whereas the EU’s budget for the year amounts to EUR129.1 billion in payment appropriations, with cohesion-related expenditures potentially available for postponement; their share in the overall budget is typically one third. The total maturing debt of EU and Euratom per annum will increase in the coming years, peaking in 2015 at less than EUR10 billion, but the ratio of maturing debt relative to the EU budget will likely remain significantly lower than 10%.
If the EU budget is insufficient to cover debt service, the European Commission has the right to call on EU member states to cover any shortfalls. Articles 310 and 323 of the Treaty on the functioning of the EU legally obligate member states to provide funds to meet all of the EU’s obligations without nationale budgetary procedures. If the EU needs to call for additional resources from member states, the amount it calls for from each member state does not have to be proportionate to that member’s contribution to the EU budget.
WHAT COULD MOVE THE RATING DOWN
Risks that would negatively affect the creditworthiness of the EU, leading to a downgrade of the EU’s rating, would include a deterioration in the creditworthiness of EU member states (as would be reflected by a downgrade in Moody’s ratings for these states). In this context, the EU’s rating is particularly sensitive to changes in the ratings of the four Aaa countries with large contributions to the EU budget, i.e., Germany, France, the UK and the Netherlands. Additionally, a weakening of the commitment of the member states to the EU and changes to the EU’s fiscal framework that led to less conservative budget management would be credit negative.
WHAT COULD CHANGE THE OUTLOOK TO STABLE
The outlook for the EU’s ratings could return to stable if the outlooks on the ratings of the key Aaa countries with contributions to the EU budget also returned to stable.