Moody's downgrades Luxembourg's outlook to negative

Dark mood among my orchids, after Moody's newest warnings. Photo ET

Moody's today revised to negative down from stable the outlooks for Luxembourg, but also for Germany and the Netherlands. All retain their Aaa sovereign ratings. Left unchanged is Finland that kept its Aaa rating and stable outlook. The reason it escaped the negative outlook that now has started contaminating the core Euroland? Finland's insistence for collateral in the Greek bailout.

Here is Moody's communiqué about Luxembourg:

MOODY'S CHANGES THE OUTLOOK ON LUXEMBOURG'S Aaa RATING TO NEGATIVE Moody's Investors Service has today changed the outlook on Luxembourg's Aaa rating to negative from stable. The Aaa rating itself remains unchanged. The key drivers of today's action on Luxembourg are: 1.) The rising uncertainty regarding the outcome of the euro area debt crisis given the current policy framework, and the increased susceptibility to event risk stemming from the increased likelihood of Greece's exit from the euro area, including the broader impact that such an event would have on euro area members, including Luxembourg. 2.) The rising contingent liabilities that the Luxembourg government will assume as a result of European policymakers' reactive and gradualist policy response, although the country's level of gross indebtedness is markedly lower than that of the other Aaa-rated euro area sovereigns. 3.) Concerns about the country's economic resilience in view of its significant reliance on financial services industry for employment, national income, and tax revenue. --RATIONALE FOR NEGATIVE OUTLOOK As indicated in the introduction of this press release, the first driver underlying Moody's decision to change the outlook on Luxembourg's Aaa bond rating to negative is the level of uncertainty about the outlook for the euro area and the impact that this has on the country's susceptibility to event risk. Specifically, the material risk of a Greek exit and the broader impact that such an event would have on euro area members exposes core countries such as Luxembourg to a risk of shock that is not commensurate with a stable outlook on their Aaa ratings. In Luxembourg's case, Moody's particular concern is over the impact that this development could have on the financial services industry, which directly accounts for 25-30% of Luxembourg's GDP. In addition, Luxembourg is exposed to a potential rise in contingent liabilities if additional euro area support is needed for banks and sovereigns in financial distress. In the case of Luxembourg, this concern is mitigated by its relatively low level of sovereign indebtedness. In light of Luxembourg's interdependence with the euro area's real economy and the global financial sector, Moody's has broader concerns about the country's economic resilience. Luxembourg's direct dependence on its financial services industry is substantial, both due to its contribution to government taxes and social security contributions (23% of the total) and to the country's employment (12% of employees). Of course, problems in the sector would inevitably generate second-order impacts on the national economy. While Moody's notes that Luxembourg's economy has a track record of being relatively resilient to shocks or crises, the above factors have prompted Moody's to examine whether this resiliency has gradually weakened. --RATIONALE FOR LUXEMBOURG'S UNCHANGED Aaa RATING Luxembourg's Aaa rating is underpinned by the country's position as one of the wealthiest countries in the world on both a GDP per capita and purchasing parity power basis. The rating also reflects the country's solid track record of economic growth, mainly driven by the financial services industry. In the past, the national authorities have been able to leverage their first-mover advantage in implementing EU directives by improving the business environment, being able to attract a highly skilled labour force and preserving some advantages related to bank secrecy legislation. Although the total assets of the banking sector and financial services' overall impact on the Luxembourg economy are very large, Moody's acknowledges that contingent liabilities emanating from it remain low. The domestic retail banking sector is dominated by three banks (Banque et Caisse d'Epargne de l'Etat, BGL BNP Paribas, BIL) and has assets that equate to just over 200% of GDP. These banks have, in aggregate, maintained strong, double-digit core Tier 1 ratios, thus capping the potential liabilities that could crystallise on the government's balance sheet. The off-shore part of the financial system is much larger and is composed of the investment fund industry (with assets under management that equate to 50x GDP) and the offshore banking operations (with assets that are 20x GDP). Moody's assesses the contagion risk between and within these different segments of Luxembourg's financial industry to be low due to minimal balance sheet linkages between the different segments of the financial sector (excluding intra-group exposures in the off-shore banking system which account for around 40% of the aggregated balance sheet of the system). The Aaa rating is supported by the very high fiscal flexibility, characterised by the low fiscal inertness of the government and its ability to adjust tax rates (especially VAT considering the structure of economy), capital expenditures (4% GDP) and social security parameters. Luxembourg still exhibits sound fiscal metrics, relative to other Aaa-rated countries, in spite of the fact that the government had to use its balance sheet to support both the economy and the banking sector during the financial crisis, which caused debt levels to increase to a still-modest 18.2% of GDP in 2011 from 7% in 2007. In addition, the government has significant financial buffers in the form of national pension fund assets that are equivalent to 27% of GDP. --WHAT COULD MOVE THE RATING DOWN Luxembourg's Aaa rating could potentially be downgraded if Moody's were to observe a large increase in the government's debt burden. Luxembourg's debt level is still low relative to rating peers, but the country's small size probably means that it is limited in its ability to take on large quantities of additional debt. More broadly, if events in the euro area develop in a way that undermines the resilience of the Luxembourg financial sector or economy, that could also result in a downgrade of the sovereign. --WHAT COULD MOVE THE OUTLOOK BACK TO STABLE Conversely, the rating outlook could return to stable if a benign outlook for the euro area, reduced stress in non-core countries and less adverse macroeconomic conditions in Europe in general were to ease medium-term uncertainties with regard to the country's debt trajectory and economic resilience.