DBRS Morningstar Confirms Grand Duchy of Luxembourg at AAA, Stable Trend

DBRS Ratings GmbH (Morningstar DBRS) confirmed the Grand Duchy of Luxembourg's (Luxembourg) Long-Term Foreign and Local Currency -- Issuer Ratings at AAA. At the same time, Morningstar DBRS confirmed Luxembourg's Short-Term Foreign and Local Currency -- Issuer Ratings at R-1 (high). The trend on all ratings is Stable.

KEY CREDIT RATING CONSIDERATIONS
The confirmation of the Stable trend reflects Morningstar DBRS' view that Luxembourg's credit fundamentals remain very strong despite a challenging macroeconomic and geopolitical environment. The country's economy is gradually rebounding from a period of lower growth. The National Institute for Statistics and Economic Studies of Luxembourg (Statec) forecasts real GDP growth to accelerate from 1.0% in 2024 to around 2.5% in 2025-26, mainly driven by monetary easing and rising external demand. However, the imposition of U.S. tariffs and the associated retaliation pose downside risks to the economic outlook. Luxembourg's fiscal results are weaker than in pre-Covid years but compare favorably with those in most other Euro Area countries. The 2025 Budget forecasts a general government budget deficit of 0.6% of GDP in 2025 after the country recorded a better-than-budgeted surplus of 1.0% of GDP last year. In Morningstar DBRS' view, while Luxembourg will continue to face modest budgetary pressures in the medium-term related to announced budgetary measures and higher defence spending pressures, the country has ample fiscal space to accommodate moderate budget deficits over the next few years without putting pressure on the AAA ratings. The share of public debt-to-GDP is low, and the government's repayment capacity is bolstered by a large stock of government assets.

The credit ratings reflect Luxembourg's very strong public finances. The credit ratings are also supported by the country's effective governing institutions and stable political environment, advanced and wealthy economy, and strong external position. These credit strengths offset the challenges associated with the economy's small size with limited diversification, vulnerability to external shocks, and exposure to potential financial stability risks.

CREDIT RATING DRIVERS
The credit ratings could be downgraded if there is a severe shock to Luxembourg's large international financial centre, most likely generated by sustained turmoil in financial markets, that has a significant impact on the economy and on public finances. The credit ratings could also be downgraded if Luxembourg's attractiveness as a business hub is damaged in such a material manner that it impacts the economy and public finances significantly.

CREDIT RATING RATIONALE

Economic Growth is Projected to Accelerate but Escalation of Trade Tensions Pose Downside Risks

Luxembourg's economy picked up last year with real GDP growth at 1.0% following two years of recession. Domestic demand drove the expansion with robust private and public consumption growth, with net exports also making a positive contribution. Real investments continued to decline with construction activity remaining sluggish. On an annual basis, Statec forecasts real GDP growth to accelerate to 2.5% and 2.4% in 2025 and 2026, respectively. The projected strengthening of growth dynamics is based on the expectation that construction investment will start to recover on the back of monetary easing, with real estate lending on the rise again already since spring 2024, and that external demand will strengthen. Private consumption is also projected to contribute positively supported by accrued savings. But the near-term economic outlook is clouded by geopolitical tensions which have not been factored into Statec's forecasts. The imposition of U.S. tariffs might weigh on the country's small and open economy. Although direct trade linkages to the U.S. are limited, the impact of higher tariffs will likely feed through to Luxembourg's economy via indirect effects. The emergence of tariff-related financial market volatility could have an adverse impact on the country's large financial sector and spillovers via indirect trade linkages or from materially weaker sentiment could further weigh on growth.

Luxembourg's credit profile is supported by its highly developed economy and its position as a global financial centre. The economy's GDP per capita amounted to EUR 126,910 in 2024. The country hosts a very large fund industry and numerous international banks and insurers. Financial sector activities accounted for 25.5% of total nominal gross value added in 2024 and constitute, together with business services (13.0%), the backbone of the economy. While ongoing changes in global corporate taxation could affect the operations of multinational companies, Morningstar DBRS believes that Luxembourg is likely to remain highly attractive as a financial hub due to a highly skilled workforce, a strong legal and regulatory environment, and political stability. Furthermore, Luxembourg's exceptionally high GNI per capita provides the country with a significant buffer against shocks. Together, these considerations support Morningstar DBRS' positive adjustment of the `Economic Structure and Performance' building block assessment.

Modest Budgetary Pressures after Better-Than-Budgeted Performance in 2024

Luxembourg's fiscal balance swung back to a surplus of 1.0% of GDP in 2024, up from a narrow deficit of 0.8% of GDP in 2023, and well above the budgetary deficit target of 0.6% of GDP. While the country's fiscal balances are weaker than in pre-pandemic years, they continue to compare favorably with most other Euro Area countries. While nominal spending levels have been pushed up by the indexation of social benefits and public wages to inflation, this has been more than offset by strong revenue growth, particularly regarding income taxes. Total general government revenues rose by 10.3% in 2024 compared to an increase of 6.1% for general government expenditure. The stronger-than-expected revenues helped the central government fiscal position to be almost balanced compared to a budgeted deficit of 1.7% of GDP in 2024, while local government and the social security recorded surpluses.

The 2025 Budget forecasts the general government budget deficit at 0.6% of GDP in 2025 and 0.5% in 2026, driven by the adoption of new tax measures in the fiscal year 2025 projected to weigh on government revenues. This includes an adjustment of personal income tax brackets by 2.5 wage-indexations and the reduction of the statutory corporate income tax rate by one percentage point. Weaker economic growth than anticipated when the budget was drafted could also result in a less favourable revenue generation, despite revenues having surprised to the upside last year. Furthermore, the government seeks to bolster activity on the domestic housing market through a large housing acquisition program of dwellings under construction with total investments of up to EUR 0.5 billion until 2027. The government will also likely be confronted with additional spending pressure for defence. Under current plans Luxembourg aims to increase defence spending to 2% of GNI by 2030 (up from an estimated 1.3% in 2024 according to NATO), but the government already signaled that the defence spending trajectory and target could be revised upwards following shifts in the U.S. administration's posture towards NATO that have prompted a new level of urgency at the EU level to increase military expenditure on the European continent. In light of these developments, Morningstar DBRS takes the view that budgetary pressures will remain larger over the medium-term than in pre-Covid years.

Credit Ratings Continue to Be Underpinned by Low Public Debt and Large Government Assets

Luxembourg's low public debt burden is a key strength of the credit rating. General government gross debt amounted to 26.3% of GDP in 2024, up from 25.0% a year prior. The 2025 Budget forecasts higher gross public debt in 2025 at 27.5% of GDP, and to decline again thereafter. Similar to the previous government, the current government follows a prudent fiscal policy. Apart from a low level of public sector debt, the government's repayment capacity is bolstered by large government assets. At the end of 2024, the general government had a net asset position of 5.6% of GDP (excluding government shareholdings in several commercial and non-commercial companies) according to the International Monetary Fund (IMF). Therefore, Morningstar DBRS assesses Luxembourg's fiscal space as very large.

Financial Condition of the Banking Sector Is Strong, but Asset Quality Risks are Tilted to the Downside

Morningstar DBRS assesses the overall financial condition of the economy's large banking sector as strong. Banks have comfortable liquidity positions and benefit from good capital buffers. Furthermore, the current stock of non-performing loans is low. However, pockets of vulnerability for asset quality could arise from higher interest rates which could strain the repayment capacity of borrowers, although risks are receding as borrowing costs fell again because of monetary easing. In February 2025, the average interest rate on outstanding loans to households and non-financial corporates stood at 3.9% (down slightly from the 4.1% peak over 2023-24) and 3.8% (down from 4.4%), respectively. Furthermore, household debt in Luxembourg is comparatively high standing at around 62% of GDP at year-end 2024 compared to an EU average of 49%. At the same time, the repayment capacity of most households is supported by large household assets and a resilient labour market as well as wage indexation. The housing market had cooled down markedly over 2023-24 because of tighter monetary policy but seems to be turning a corner with prices stabilizing. Net assets of the large investment industry grew by 10% over 2024, according to data by the central bank, with the industry again recording net capital inflows in 2024 after registering net redemptions over 2022-23. However, elevated global financial volatility could influence the performance of the large investment fund industry going forward. Asset quality risks from higher for longer interest rates and potential spill-over risks from global financial market volatility to the country's large and interconnected financial system are weighing on Morningstar DBRS' assessment of the `Monetary Policy and Financial Stability' building block.

The External Position Is Strong and Influenced by the Multinational Sector

Luxembourg's external position benefits from persistent current account surpluses on the back of high net exports of financial services and a large net external asset position. The current account surplus amounted to a large 13.8% of GDP in 2024 and is projected to remain elevated over the medium-term at around 8.0% of GDP according to IMF forecasts. The country also has a large net asset position, with a net IIP standing at 37.6% of GDP at year-end 2024. Luxembourg's international investment position is heavily influenced by the activities of multinational companies and the financial sector. It commands a very high net creditor position in direct investments which, according to data by the central bank, largely relates to special purpose vehicles. The economy exhibits a very large negative portfolio investment position due to a substantial stock of investment fund shares held by non-residents. While Luxembourg is a small economy in a monetary union with limited capacity for external adjustment, the country's extensive financial and trade linkages throughout Europe reduce external risks and support Morningstar DBRS' positive adjustment of the `Balance of Payments' building block assessment.

Luxembourg's Credit Rating Is Underpinned by High Institutional Quality

High institutional quality is a key strength of Luxembourg's credit profile. The country is a strong performer on the World Bank's Worldwide Governance Indicators, reflecting a high level of rule of law and low levels of corruption. Furthermore, policy continuity is high. The change in government after the October 2023 elections did not alter the overall direction of government policy, as there is a broad consensus among the main political parties on key policy topics, including fiscal, macroeconomic and foreign affairs. The current government coalition is comprised of the two centre-right parties, the Christian Social People's Party and the Democratic Party.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

There were no Environmental, Social or Governance factors that had a significant or relevant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (13 August 2024) https://dbrs.morningstar.com/research/437781.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/453091.

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in euros unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments (15 July 2024) https://dbrs.morningstar.com/research/436000. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings https://dbrs.morningstar.com/research/437781 in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

The sources of information used for these credit ratings include the Government of Luxembourg (Évolution de l'effort de défense: 2% en 2030, June 2024; Press Conference 14 February 2025), Ministry of Finance (Budget 2025, October 2024; National Medium-Term Fiscal-Structural Plan, October 2024), Trésorerie de l'Etat, National Institute of Statistics and Economic Studies of the Grand Duchy of Luxembourg STATEC (Note de Conjuncture, December 2024; Conjuncture Flash, January-March 2025; Statistical tables), Banque Centrale du Luxembourg (Financial Stability Review 2024, August 2024; Bulletin 2025/1, January 2025; Statistics), Commission de Surveillance du Secteur Financier (CSSF), Statistical Office of the European Communities, European Commission (European Economic Forecast, Autumn 2024, November 2024; Commission opinion on the 2025 Draft Budgetary Plan of Luxembourg, November 2024; Debt Sustainability Monitor 2024, March 2025), European Central Bank, European Systemic Risk Board, European Banking Authority, European Parliament (Luxembourg's climate action strategy, March 2025), European Environment Agency (EEA Effort Sharing Decision Dataset, October 2024), OECD, Bank for International Settlements, International Monetary Fund (WEO and IFS; 2024 Article IV Consultation Report Luxembourg, June 2024; IMF Staff Concludes Visit to Luxembourg, March 2025), World Bank, NATO, AlTi Global Social Progress Index and Macrobond. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, these are unsolicited credit ratings. These credit ratings were not initiated at the request of the issuer.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: NO

Morningstar DBRS does not audit the information it receives in connection with the credit rating process, and it does not and cannot independently verify that information in every instance.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS' outlooks and credit ratings are under regular surveillance.

For further information on Morningstar DBRS historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication. For further information on Morningstar DBRS historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at: https://www.dbrsmorningstar.com/research/453092.

These credit ratings are endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Max Dietz, Assistant Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Global Sovereign Ratings
Initial Rating Date: 16 December 2016
Last Rating Date: 08 November 2024

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