Fitch Affirms Luxembourg at 'AAA'; Outlook Stable

Fri Jan 24, 2014 12:11am EST

LONDON, January 24 (Fitch) Fitch Ratings has affirmed Luxembourg’s Long-term foreign and local currency Issuer Default Ratings (IDR) at ‘AAA’ with Stable Outlooks. The issue ratings on Luxembourg’s senior unsecured foreign and local currency bonds are also affirmed at ‘AAA’. The Country Ceiling has been affirmed at ‘AAA’ and the Short-term foreign currency IDR at ‘F1+’. KEY RATING DRIVERS The affirmation reflects the following factors: Luxembourg is a very high-income, ultra-open economy with favourable macroeconomic dynamics compared to other eurozone countries. Luxembourg had one of the strongest recoveries in the eurozone in 2013 as GDP growth accelerated to almost 2%, following a 0.2% contraction in 2012. The robust performance of the Luxembourg economy is reflected by GDP being 2.5% higher than in early 1Q11, while in the eurozone it is still 0.9% below the 1Q11 level. However, growth is more volatile than ‘AAA’ peers due to Luxembourg’s small size and the importance of the financial sector. Luxembourg has a strong public finance position, although it faces increasing fiscal challenges over the coming years. Social security reserves, close to 30% of GDP in 2013, exceeding the gross debt level (25% of GDP in 2013) provide the sovereign with extra financing flexibility. The projected rise in ageing-related expenditure until 2060 under current parameters remains among the largest in Europe, despite the pension reform measures adopted in December 2012. However, most of this projected fiscal burden would only materialise after 2030. The general government budget deficit/GDP ratio remained low in 2013, likely close to the 0.6% in 2012. Fitch forecasts the deficit to gradually increase in 2014 and 2015, in particular as the sharp reduction in e-commerce VAT revenues (1.5%-2.0% of GDP, starting in 2015) will not be fully or immediately compensated by fiscal tightening measures. As noted by the European Commission, this also implies that Luxembourg will fail to converge towards its medium-term objective of 0.5% budget surplus, as required by the reinforced Stability and Growth Pact. The dominance of the internationally-oriented financial sector in a small open economy has non-negligible macroeconomic, and ultimately fiscal, risks. Notwithstanding the strength of Luxembourg’s business model and comparative advantages the country has built up over the past decades, for example in fund management, finance is a risky and often volatile industry, exposed to exogenous shocks, especially in a monetary union undergoing structural changes. While the size of the financial sector, 70x GDP (including investment funds), is not in itself a relevant indicator of the potential risks, the broad financial sector’s share in GDP, including advisory and auxiliary services, exceeds 30% and its future development is important for the economy’s growth outlook. Luxembourg has a strong external balance sheet, although its gross debt and asset position is volatile as it is inflated by the financial sector. Its net international investment position was strongly positive at 170% of GDP in 2012. The current account has been in surplus for more than two decades, in the range of 5%-8% of GDP since 2008. Luxembourg ranks highly on all World Bank governance indicators, in line or exceeding ‘AAA’ medians. Its institutional strengths foster confidence in its ability and willingness to honour its public debt commitments. RATING SENSITIVITIES The Outlook is Stable. Consequently, Fitch's sensitivity analysis does not currently anticipate developments with a high likelihood of leading to a rating change. However, future developments that could individually or collectively, result in a downgrade of the ratings include: - Major turbulence in the financial sector would pose limited direct risks through additional direct and/or contingent liabilities to the sovereign. The cumulative size of the systemically important domestic banks is moderate relative to Luxembourg’s sovereign and these banks are fairly insulated from the internationally-oriented banks and investment funds. Nevertheless a sudden, deep fall in the activity of the financial sector overall could have a significant adverse macroeconomic impact, including on the labour market, with knock-on effects on public finances as well. - Re-intensification of the eurozone crisis. The balance sheet of the Eurosystem substantially increased during the crisis and Luxembourg has built up by far the largest cross-border claim (Target2 balance) relative to its economy. The exposure was 230% of GDP in November 2013 and did not decline during 2013, unlike other surplus countries, Germany or the Netherlands. Fitch recognizes that direct losses would materialise only in an extreme scenario of full break-up of the monetary union. KEY ASSUMPTIONS Fitch assumes that the new government formed in December 2013 will maintain economic policy continuity. Based on the government programme, Fitch assumes that medium-term fiscal policy will be consistent with the path described in the 2013 Stability Programme. Fitch expects the 2015 budget will include a comprehensive consolidation strategy, involving both revenue and expenditure measures to counterbalance the loss of e-commerce VAT revenues. The 2014 budget, which will only be adopted in April 2014 due to the formation of the new government, is unlikely to contain major policy measures. Fitch forecasts GDP growth of 1.8% in 2014, based on the strong carry-over from 2013 and the gradual eurozone recovery. Growth will likely slow to 1.4% in 2015, as fiscal consolidation will start to constrain domestic demand. Inflation will remain below 2% until 2015, driven mainly by the generally very low inflation trend in the eurozone. However, the planned VAT tax hike could lead to more persistent inflation pressure due to the wide-spread wage indexation in the economy. Fitch assumes that the sovereign will not provide any support to the financial sector beyond the domestically active banks even in case of a large adverse shock to the financial sector. The domestic balance sheet of the three largest Luxembourg banks is less than 200% of GDP with healthy to solid capital positions and robust asset quality due to the generally sound balance sheet position of the domestic sectors and economic growth. Fitch assumes the gradual progress in deepening fiscal and financial integration at the eurozone level will continue; key macroeconomic imbalances within the currency union will be slowly unwound; and eurozone governments will tighten fiscal policy over the medium term. It also assumes that the risk of fragmentation of the eurozone remains low. Contact: Primary Analyst Gergely Kiss Director +44 20 3530 1425 Fitch Ratings Limited 30 North Colonnade London E14 5GN Secondary Analyst Amelie Roux Director +33 1 44 299282 Committee Chairperson Paul Rawkins Senior Director +44 20 3530 1046 Media Relations: Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: peter.fitzpatrick@fitchratings.com. 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