04 Jun 2020

Next Generation EU bonds might face a credit-rating challenge


If fully implemented, the Commission’s Next Generation plan would increase the EU’s financial obligations fifteen-fold. Two-thirds of the envisaged €750 billion of bonds receipts will fund grants and, for the first time, will therefore not be backed by individual member states borrowing the proceeds from the EU. When releasing the plan, the Commission confidently stated that this massive borrowing programme would be supported by its “very strong credit rating”.  Indeed, the EU currently enjoys a top-notch AAA-rating from all agencies except Standard & Poors (who give it an AA-rating). All agencies currently assign a stable outlook to their respective ratings, indicating that they expect the rating to remain unchanged for the next two to three years. But will this constructive view survive contact with the new reality of the EU and its massive ramping up of debt?

Let us look at the credit factors supporting the EU’s ratings and ask whether those strengths may be diluted once the EU’s ambitious plan becomes reality.

Financial support by highly rated net contributor member states. All rating agencies view the EU’s AAA-rated member states’ ability and willingness to support the EU budget as pivotal. In the EU’s case this extraordinary support is especially important because the EU does not enjoy a cushion of paid-in capital as other multilateral issuers do – the European Investment Bank (EIB) and the European Stability Mechanism (ESM), for example.

Under Article 323 of the TFEU, member states are legally obliged to “ensure that the financial means are made available to allow the Union to fulfil its legal obligations in respect of third parties.” This is a loose form of callable capital. It suffers from the same agency problem as conventional callable capital: the actors making the call are the same ones having to make the payment. Given the untested nature of capital calls, rating agencies have treated callable capital as less secure than paid-in capital. This would be even more true for the more undefined obligation to make good on any shortfall in the EU budget. Without a capital buffer or legally enforceable guarantees, uninterrupted and unwavering AAA-member support is critical.

When assessing the risk embedded in future EU debt issues, rating agencies will most likely monitor the negotiating stance of AAA members. Any signs that they might try to limit their contingent liabilities towards the EU could be interpreted as an indication that the hitherto steadfast support could slowly become more conditional. That would be negative for the EU’s ratings.

There have been several layers of protection safeguarding the EU’s debt service capabilities. All may be weakened by the ramping up of EU debt issuance.

The first line of defence for debt service has been the repayment from the sovereign member state to which the receipts were on-lent. This line of defence would be absent for the share of the EU bonds (€500 billion) that will fund the grant component.

The second line of defence is the so-called own resources. The current Commission proposal envisages no debt redemption until 2028. Until then, no member state has to make any financial commitment. This unforced delay in itself is not reassuring. If there is no appetite to make hard choices now, why would it be any easier in seven years’ time, when the sense of emergency will probably have waned? A commitment to pay back some bonds during the upcoming MFF2021-27, and allocate resources accordingly, could act as a strong political commitment.

Moreover, the EU budget has always been designed with a safety margin. The so-called fiscal headroom is the difference between the own resource ceiling (the maximum amount for which member states are on the hook) and the expenditures legislated in adopted budgets. Should it become necessary, the EU can call on its member states to pay the EU up to the resource ceiling to secure debt service. The size of the fiscal headroom will become much smaller as a share of the financial obligations due from 2028 onwards. A binding commitment now to increase the headroom in the MFF 2028-34 commensurate with the scheduled rise in debt service would be a powerful positive signal.

Budgetary flexibility. Under the new plans the debt maturing every year during 2028-58 would average €25 billion, potentially 15-20% of the total annual budget and a tenfold increase over present debt service. The budgetary flexibility to defend debt service will therefore be greatly diminished.

The EU’s financial credit metrics are likely to weaken once its borrowing is ramped up. This could put downward pressure on its credit ratings. Nevertheless, rating agencies may well affirm the EU’s AAA status. The ratings methodologies applied by the agencies allow a fair amount of analytical discretion. Agencies may interpret the recovery package as a positive sign that, when push comes to shove, member states coalesce around the common interest of the Union as a whole. Much will depend on how constructive negotiations turn out to be in the coming weeks. It would be imprudent to ignore downgrade risks.

At the same time, a downgrade would not be a serious problem. Under current credit conditions the yield of a ten-year EU-bond would be near 0%. A downgrade may raise funding costs by some ten basis points. Once all €750 billion are outstanding, the additional interest costs would amount to €750 million per year. That is equivalent to €1.70 per EU inhabitant. Or the price of one cup of coffee. The loss of AAA is possible, but it would not be a game changer.

Moritz Kraemer is currently Chief Economic Advisor at Acreditus and until 2018 was Sovereign Global Chief Rating Officer for S&P Global Ratings.