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Fitch Affirms Luxembourg at 'AAA'; Outlook Stable
October 14, 2016 / 8:17 PM / a year ago

Fitch Affirms Luxembourg at 'AAA'; Outlook Stable

(The following statement was released by the rating agency) LONDON, October 14 (Fitch) Fitch Ratings has affirmed Luxembourg's Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) at 'AAA'. The Outlooks are Stable. The issue ratings on Luxembourg's senior unsecured Local Currency bonds have also been affirmed at 'AAA'. The Country Ceiling has been affirmed at 'AAA' and the Short-Term Foreign and Local Currency IDRs at 'F1+'. KEY RATING DRIVERS Luxembourg's 'AAA' IDRs reflect the following key rating drivers: Luxembourg's rating balances its high income per capita, strong governance indicators, high growth potential and solid public finances against higher macroeconomic volatility, and heavy reliance on the financial services sector. Public finances are a key rating strength for Luxembourg, with a five-year average budget surplus of 1.0% of GDP, compared with a deficit of 0.5% for the 'AAA'-median. The government has been implementing mild fiscal consolidation since the 2015 budget in October 2014, to offset the loss of e-VAT revenues due to a change in EU rules to allocate tax revenues on online purchases to the customer's country. The general government surplus was 1.6% of GDP in 2015, and Fitch expects a slight narrowing to 1.2% of GDP in 2016. Fitch forecasts the 2017 budget balance to weaken to 0.1% of GDP, due to the government's tax reform measure, and to remain broadly balanced in the medium term. The measures represent an easing in the annual tax burden by 0.8% of GDP according to the government's estimates, phased in over 2017-18, with four-fifths of the impact aimed at raising household disposable income, and the remaining impact benefiting businesses. This includes a fall in the corporate tax rate to 26% from 29% by 2018. The fiscal balance is also worsened by the impact of the automatic wage indexation exercise on public wage expenditure, but our projection excludes an expected additional rise in public sector wages as a result of the wage negotiations due in 2017-18. Public debt is the lowest amongst 'AAA' rated sovereigns at 22.6% of GDP in 2016, and is forecast to rise only slightly to 23.0% of GDP in 2018. The potential recapitalisation of the central bank, which currently has the lowest capital ratio amongst Eurosystem central banks, is still in discussions and Fitch estimates this could cost the government 1% of GDP. The fiscal costs of Luxembourg's ageing population pose a risk to public finance sustainability beyond the rating horizon. Despite the 2013 pension reforms, the projected long-term increase in age-related spending remains one of the highest across the EU. Fitch does not expect significant further reforms to be passed before the 2018 elections. Anti state-aid proceedings by the European Commission (EC) on Fiat-Chrysler, McDonalds and Amazon could lead to these companies having to repay Luxembourg taxes retrospectively, resulting in one-off boosts to fiscal revenues. Luxembourg is appealing the Fiat-Chrysler ruling. Luxembourg has a strong net external creditor position of 2,283% of GDP, mainly accruable to the international banks, investment funds and multi-national corporations. The country has benefited from more than two decades of large current account surpluses, driven by a large net services surplus. However, the current account surplus has declined to 5.2% of GDP in 2015 from 12% in 2004, owing to a worsening of the primary income deficit. Luxembourg's economy has experienced robust growth, outpacing its EU (2015: 2.2%) and eurozone (2015: 2.0%) neighbours. Real GDP grew by 3.5% in 2015 and is forecast to grow 3.4% in 2016 and 3.6% in 2017. While financial sector growth will slow after rapid expansion in 2015, households' disposable incomes will benefit from the government's tax reform measures (announced in February 2016) and from a wage hike as the automatic wage indexation mechanism is estimated to be triggered around end-2016 according to STATEC. These factors could see household disposable income rise by 5%-6%. Inflation is forecast to be low at -0.1% in 2016 due to lower oil prices, picking up to 1.8% in 2017 as the falling oil prices drops out of the equation and the wage increase at end-2016. Aggregate net asset valuation of Luxembourg's investment funds industry has fluctuated around the EUR3.5trn level in the 15 months to May 2016. In most months, the funds industry reports positive net inflows of capital investments, albeit at a slower pace in recent months than the growth in 2014-15. Volatility in the financial markets in autumn 2015 (due to news of China's rebalancing) and January 2016 have contributed to the slowdown of net asset values. However, Fitch also expects a general slowdown in the pace of funds growth from the high annual average growth of 21.6% yoy in 2015. Luxembourg's financial sector is large, with total assets amounting to 70x GDP, contributing 27% of GVA and 12% of employment. The sector mainly comprises investment funds and internationally-oriented banks, which expose the economy's growth and labour market to shocks from the international financial markets. Interconnectedness between the domestic banks is relatively low, and their exposure to banks established abroad is mostly limited to intragroup linkages. The banking sector is resilient with a strong Tier 1 capital adequacy ratio of 20% and a non-performing loan ratio under 1%. However, housing prices have experienced very robust growth of an annual average growth of 4.7% yoy over the past six years and require further monitoring. The near-term impact of the Brexit vote is expected to be negative on the eurozone and Luxembourg as the volatility in the financial markets and uncertainty across the eurozone dampens investments in the UK and the eurozone. In the medium to long term, the impact of Brexit on Luxembourg is highly uncertain, and depends on the eventual deal that the UK is able to negotiate with the EU, with the possibility of positive gains to the extent that some limited banking sector operations and more investment fund activity are relocated to Luxembourg. SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO) Fitch's proprietary SRM assigns Luxembourg a score equivalent to a rating of 'AAA' on the Long-Term FC IDR scale. Fitch's sovereign rating committee did not adjust the output from the SRM to arrive at the final LT FC IDR. Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM. RATING SENSITIVITIES The Outlook on Luxembourg's Long-term IDRs are Stable. Consequently, Fitch does not currently anticipate developments with a significant probability of leading to a rating change. Notwithstanding this, future developments that could result in a downgrade include: A severe sudden contraction of financial sector activity in Luxembourg could have adverse consequences for the real economy, negatively impacting Luxembourg's labour market conditions and public finances. KEY ASSUMPTIONS Fitch assumes that the changes to the international corporate tax framework across the EU would not result in a large-scale migration of operations out of Luxembourg by Luxembourg-based multinational corporations. Fitch assumes that new structural reforms to the pension system will be enacted by the government to offset the fiscal costs of Luxembourg's ageing population, which are currently projected to increasingly weigh on public finances over the next decade. Fitch assumes that the sovereign will not extend support to the internationally-oriented financial institutions, even in the event of a systemic shock to the wider financial sector. Fitch believes that in a severe financial crisis, some losses to the domestically-oriented Luxembourg banks (banking sector assets of 189% of GDP at end-2015) could still materialise on the sovereign's balance sheet. Contact: Primary Analyst Eugene Chiam Associate Director +44 20 3530 1512 Fitch Ratings Limited 30 North Colonnade London E14 5GN Secondary Analyst Douglas Winslow Director +44 20 3530 1721 Committee Chairperson Jan Friederich Senior Director +852 2263 9910 Media Relations: Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: Additional information is available on Applicable Criteria Country Ceilings (pub. 16 Aug 2016) here Sovereign Rating Criteria (pub. 18 Jul 2016) here Additional Disclosures Dodd-Frank Rating Information Disclosure Form here _id=1013177 Solicitation Status here Endorsement Policy here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: here. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEB SITE AT WWW.FITCHRATINGS.COM. PUBLISHED RATINGS, CRITERIA, AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. 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