OREANDA-NEWS. 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 foreign and local currency bonds have also been affirmed at 'AAA'. The Country Ceiling has been affirmed at 'AAA' and the Short-term foreign currency IDR at 'F1+'.

KEY RATING DRIVERS
Luxembourg's 'AAA' IDRs reflect the following key rating drivers:

Luxembourg is a small, very wealthy economy, with a high degree of trade openness relative to its peers. It has strong stable institutions, which contribute to its high World Bank governance scores.

Public finances are a key rating strength, with a five-year average general government surplus of 0.6% of GDP, and a low gross general government debt/GDP ratio of 23.4% at end-2015. The government is implementing a mild fiscal consolidation strategy in 2015-2019 to offset the structural loss of e-VAT revenues arising from a change the EU law governing tax receipts from internet sales (worth 2.3% of GDP in 2014).

Initial estimates for the consolidation effort have been revised down from a cumulative 1.7% of GDP by 2018 in the 2015 budget, to 1.4% of GDP by 2019 in the 2016 budget, primarily due to a re-estimation of the impact of the 2pp VAT rate increase measure in January 2015. The consolidation effort for 2015 has hence decreased to 0.7% of GDP in the 2016 budget from 1.0% of GDP in the initial budget, with the VAT increase making up roughly half of the impact. Fitch does not expect any significant new measures to be announced for 2016. Despite this slippage, we estimate the 2015 general government surplus at 0.4% of GDP due to lower expenditure from postponements in investment projects and moderated public wages.

Rising pension costs from Luxembourg's ageing population pose a risk to public finance sustainability in the Grand Duchy in the long term. Despite pension reforms enacted in 2013, the projected fiscal costs of ageing remain some of the highest in the EU. Fitch considers it unlikely that significant reforms will be passed before the 2018 elections.

Real GDP growth in Luxembourg has been dynamic, with a five-year average of 2.6%, outperforming 'AAA' and eurozone peers. 1Q (-0.3%qoq) and 2Q (-0.9%qoq) growth figures in 2015 indicated a technical recession, but the effect of the VAT increase measure and other robust short-term indicators suggest that the growth figures could be revised up. Fitch forecasts 2015 growth to be 3.1%, accelerating to 3.3% in 2016. Inflation was 0% in 2015 and has been driven by declining oil prices in 2015, more than off-setting the effect of VAT increase on prices.

Luxembourg's external position is a key rating strength, with more than two decades of large current account surpluses, driven by a large surplus in net services. However, this has been gradually declining, from 12.0% of GDP in 2004 to 4.2% of GDP in 2015. The persistent current account surplus has led to a significant growth in the net international investment position of 37% of GDP. Luxembourg also has a large net external creditor position of 1997% of GDP, which is mainly due to the international banks, investment funds and multi-national corporations.

Luxembourg's financial sector is large, with total assets of 70x GDP, and accounts for roughly 27% of Luxembourg's GDP and 12% of employment. The sector is dominated by internationally-oriented banks and investment funds that make the small open economy vulnerable to shocks from international financial markets. The investment funds industry proved resilient through the market volatility in 3Q15, recording positive net capital inflows despite some valuation losses. Domestic banks' exposure to the international banks is limited to their use of interbank funding.

RATING SENSITIVITIES
The Stable Outlook reflects Fitch's assessment that downside risks to the rating are currently moderate. However, the main factor that could result in negative rating action is:
- 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 there will not be a large-scale migration of operations out of Luxembourg by Luxembourg-based multi-national corporations arising from the impact of the Base Erosion Profit-Sharing (BEPS) measures being adopted into EU law.

Fitch assumes that the government will adopt new structural reforms to offset the projected increase in pension costs arising from Luxembourg's ageing population problem. Failure to introduce timely reforms could result in the sovereign's rating gradually coming under pressure 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.