OREANDA-NEWS. Fitch Ratings has affirmed Belgium's Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) at 'AA' with Negative Outlooks. The issue ratings on Belgium's senior unsecured Foreign and Local Currency bonds have also been affirmed at 'AA' and the issue rating on commercial paper at 'F1+'. The Country Ceiling has been affirmed at 'AAA' and the Short-Term Foreign-Currency IDR at 'F1+'.

KEY RATING DRIVERS

Belgium's 'AA' IDRs reflect the following key rating drivers:

Belgium's ratings balance the government's high public debt burden and persistent fiscal slippage in recent years against the economy's substantial net external creditor position, strong governance indicators, high income per capita and record of macroeconomic stability.

Belgium's gross general government debt/GDP is the highest among 'AA' rated sovereigns at 106.1% in 2015. Fitch forecasts debt to rise to 106.3% of GDP in 2016 (against a 'AA' peer median of 39%), following a 0.5pp fall in 2015 after KBC repaid the remainder of its financial sector support loan worth 0.7% of GDP. Fitch expects debt/GDP to remain above 100% until 2020 (unchanged from our previous review). Sovereign refinancing risk for Belgium is low, due to a long average debt maturity of 8.5 years, and a low average weighted bond yield of 2.7%. The government debt portfolio is predominantly euro-denominated.

The government's fiscal targets have faced successive downward revisions since October 2014 when the new government decided to soften near-term fiscal consolidation while it pursued structural reforms aimed at stimulating economic growth. The 2016 Stability Programme's new target deficit of 2.5% of GDP for 2016 is up from 2.0% in the 2015 Programme, and reflects 0.3pp of extraordinary spending for asylum seekers and higher security expenses following the March terrorist attacks in Brussels, and lower revenues from the government's strategy to shift taxes away from labour. The government's target deficit of 1.4% of GDP for 2017 is up from 1.0% a year earlier, and partly reflects a worse starting position.

Fitch forecasts a slightly larger deficit than the authorities of 2.7% for 2016, reflecting implementation risks around the remaining 2016 measures, and despite an expected decline in interest expense of 0.3pp of GDP. The agency also forecasts a larger deficit of 1.8% of GDP for 2017, reflecting a more challenging environment for public expenditure cuts with ongoing labour strikes. Risks to Fitch's forecasts are tilted to the downside due to likely negative revisions to Belgium's growth outlook resulting from the UK leaving the European Union (EU).

The European Commission (EC) concluded in its May 2016 assessment of the Stability Programme that Belgium was considered to be compliant with the transitional debt rule in 2015, but was not forecast to be compliant in 2016. The EC also concluded that the government was compliant with the preventive arm of the Stability and Growth Pact for 2015, but risks some deviation from the adjustment path towards the medium-term objective (MTO) in 2016 from an overall assessment, after taking into account the exercising of additional 0.3pp of GDP of flexibility clauses in 2016. However, they point to a risk of significant deviation from the adjustment path towards the MTO in 2017.

The government has been implementing structural reforms that will benefit competitiveness, including a cut to employer's social security contributions by 1% and a temporary freeze to the wage indexation mechanism in 2014-15. These measures are estimated to lower wage costs by 2%-3% in 2016 and have partially reversed the erosion of Belgium's cost competitiveness relative to its neighbours. The government also passed pension reforms at end-2015 to strengthen the age and career requirements for pensions, removing incentives for early retirement and reducing public pension payouts. This is estimated to result in fiscal costs of ageing halving to 2.1pp of GDP by 2060.

Fitch forecasts real GDP to grow by 1.2% in 2016 and 1.5% in 2017 and 2018. Fitch trimmed its growth forecast for 2016 since its previous review (1.3%) to reflect the impact of the March terror attacks on the tourism and hospitality sector. Growth is expected to be driven by private consumption and investments, with net exports recovering only modestly due to weak external demand. Downside risks to the forecasts include the impact of the recent labour strikes, and the impact of reduced UK and global demand from the UK's decision to leave the EU. The UK accounts for 9.5% of Belgian goods and services exports, higher than the EU average of 5.2%.

Inflation was weak in 2015 at 0.6% owing to falling energy prices and weak demand, but is forecast to rise faster than the eurozone average to an average of 1.7% in 2016-17 due to rises in VAT on electricity, excise duties and administered prices. This could erode Belgium's competitiveness gains in recent years as the wage indexation mechanism is reactivated in 2016.

The economy has a strong net external creditor position of 51% of GDP attributable to Belgian households and corporations. Belgium's current account has improved to a surplus of 0.2% of GDP in 2016 due to the falling price of oil imports and better export performance in recent years.

Fitch-rated Belgian banks have a weighted-average viability rating of 'a', consistent with other 'AA' rated peers. This reflects the good health of the Belgian banking sector, with profitability and capitalisation metrics improving, and non-performing loans at a low level of 3.6% of total loans at end-2015. Government guarantees to the state-owned bank Dexia remained large at EUR34.7bn at May-2016 (8.1% of GDP).

SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)

Fitch's proprietary SRM assigns Belgium a score equivalent to a rating of 'AA' on the Long-term FC IDR scale.

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:

- Public finances: -1 notch, to reflect high gross general government debt/GDP and sizeable contingent liabilities in the form of government guarantees on Dexia's debt. The SRM is estimated on the basis of a linear approach to debt/GDP and does not capture the higher risk at high levels of debt/GDP.

- External finances: +1 notch, to reflect Belgium's large net external creditor position relative to 'AA' peers, which is not captured by the SRM.

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 Negative Outlook reflects the following risk factors that may, individually or collectively, result in a downgrade:

- Further slippage in the government deficit reduction path, leading to a slower debt reduction trajectory.

- Persistently weak GDP growth.

The Negative Outlook means Fitch's analysis does not currently expect developments with a material likelihood of leading to positive rating action. Nonetheless, future developments that may individually or collectively lead to positive rating action are:

- Improved confidence in the government's ability to reduce the budget deficit and place public debt/GDP on a sustained downward trajectory.

- Strengthening growth prospects and competitiveness, particularly through implementation of structural reforms.

KEY ASSUMPTIONS

In its debt sensitivity analysis, Fitch assumes a primary surplus averaging 1.4% over the next 10 years, trend real GDP growth averaging 1.1%, an average effective interest rate of 2.8% and GDP deflator of 2.0%. Based on these assumptions, the debt/GDP ratio would rise slightly to 106.3% in 2016 before declining to 105.2% in 2017 and 90.5% by 2025.

Fitch will update its forecasts for the eurozone in July in the light of the outcome of UK's referendum to leave the EU. This will likely lead to some moderate downward revision of forecasts for Belgium's GDP growth, which would likely have some adverse impact on the budget deficit, absent a policy response.