After triggering negotiations to exit the EU, the U.K. government will likely face a request from the European Commission to honor its existing financial obligations, which reportedly could reach €60 billion. As this claim is unlikely to be legally enforceable, we expect any solution will be the outcome of a political compromise, rather than legal in nature.
We believe that the extent of the U.K. government's willingness to make good on reasonably established financial demands by the EU could serve as a proxy case for sovereigns' future willingness to honor similarly unenforceable sovereign obligations that underpin our ratings on some multilateral lending institutions. These obligations include callable capital or other future payment promises. Indeed, the European Union (EU; AA/Stable/A-1+) ratings could come under pressure in an adverse scenario. This is because our ratings on the EU are to a certain extent predicated on our expectation that the U.K. would honor its share of financial obligations to the EU. The risk to other supranationals would be more muted and indirect.
- We believe that the U.K. could face a Brexit divorce bill of up to €60 billion from European Commission negotiators.
- We expect the final settlement is likely to be the result of political negotiations, since the claim is probably not legally enforceable.
- We believe the extent of the U.K.'s willingness to make good on these financial demands could serve as a proxy case for sovereigns' future willingness to honor similarly unenforceable obligations that currently underpin the ratings of multilateral lending institutions.
- In an adverse scenario, the ratings on the EU itself could come under pressure, and other supranationals could face indirect risks.
The Contentious "Brexit Bill"
We expect that relatively early in the U.K.'s negotiations to exit the EU, the European Commission negotiation team will confront the U.K. government with a summary of financial obligations that Brussels believes the U.K. would still owe after departing. The amount could be as high as €60 billion, according to press reports, although no detailed list has been published. This amount would contain, among other things, the U.K.'s proportional share of the EU's current engagements and remaining budget contributions until 2020, when the current seven-year multiannual EU financial framework ends. It would also include a proportional share of the EU's large and underfunded pension and other employee liabilities at over €60 billion.
The U.K. government has been careful not to make any public announcements on any financial cost of withdrawal. For example, it made no reference to it in the Brexit White Paper released on Feb. 2. At the same time, however, some prominent pro-Brexit MPs of the ruling Conservative Party have publicly rejected that the government owes the EU anything. Some Brexit supporters argue, based on legal opinions, that the EU has its own separate legal personality and is responsible for settling its own debts. We do not expect that the U.K. would take such an absolute "hands off" negotiating position. Under this interpretation, member states, being distinct legal entities, would not have any automatic legal obligation to step in for the EU. While there is a binding commitment of member states under which the EU can call on resources, this only applies pro rata to all members and would therefore not apply to the U.K. post Brexit (see text box). We understand that doubts loom large also among the remaining EU members regarding the legal enforceability of the alleged U.K. liabilities.
The EU's Claim On Member States
The EU has a contingent claim ("fiscal headroom") on EU members, which we expect will average 0.28% of gross national income (or about €30 billion annually) over the 2014-2020 multiannual financial framework. EU members have made this pledge for the express purpose of backing the EU's financial obligations. Both this pledge and any budgetary payments are joint and several obligations of EU members. We believe, however, that the willingness of sovereigns rated at or above the level of the rating on the EU to fulfill this joint and several pledge might be tested if some other members are unwilling to honor a capital call on a pro-rata basis. (see: "Rating On Supranational Institution The European Union Affirmed At 'AA'; Outlook Stable," Aug. 18, 2016).
This confluence of positions suggests that the decision about how much, if anything, the U.K. will eventually pay the EU will be the result of a political process. As such, negotiators will discuss it in the context of many other contested issues, possibly leading to trade-offs. The EU rating itself could come under pressure should the U.K. fail to make good on its obligations in full and on time. The current EU rating is predicated on our expectation that "the U.K. would honor its share of financial obligations to the EU". In any case, if the U.K. were to decide not to pay the so-called Brexit bill, this would not constitute a sovereign default. Our sovereign methodology is very explicit that failure to pay obligations to supranationals and other official creditors does not fall under the default definition as applied by S&P Global Ratings.
A Parallel To Callable Capital?
It is too early to speculate on a final agreed sum--or whether an agreement will be found at all. S&P Global Ratings will carefully monitor the negotiations. We will do so with a view to assess whether the form and the outcome of the negotiations could provide any guidance on how a sovereign might react if supranationals other than the EU were to make similar legally unenforceable calls on its sovereign shareholders.
We make a distinction between supranationals like the EU itself, which fully depend on regular payments by its members, and multilateral lending institutions (MLIs) with paid-in capital and proprietary earnings capacity. The latter are much less dependent on the continuous good will of their members. The ratings on them should therefore be more resilient to a negative outcome over the Brexit bill negotiations.
The ratings on a number of multilateral lending institutions (MLIs) depend on unenforceable promises by their sovereign shareholders to make future payments if and when they are called upon. The most common among these is "callable capital". Callable capital corresponds to a commitment by each shareholder to pay in additional capital, but generally only when necessary to avoid an MLI's default. An MLI's callable capital is typically a multiple of its paid-in capital. If a capital call is made, each shareholder is typically responsible for meeting a call on capital, even if other shareholders do not.
Capital calls and the U.K. Brexit bill have three commonalities:
- They are both legally unenforceable;
- They are both without precedent; and
- They are both financial demands of supranational institutions on sovereign shareholder states.
These similarities could make the now ensuing discussion on the U.K.'s obligation an interesting proxy case for hitherto unobserved capital calls.
We assign value to the callable capital because we believe these commitments are credible and constitute a strong incentive for the shareholders to support an MLI in times of stress. We do this in full recognition of related risks, such as appropriation risks in shareholder sovereigns or the agency problem. The latter relates to the fact that the MLI's board of governors or board of directors, who are typically responsible for initiating a capital call, tend to be the representatives of the very sovereigns they demand payment from.
Callable capital can raise the rating on an MLI by up to three notches above the stand-alone credit profile (SACP)--the SACP excludes rating uplift for sovereign shareholders' extraordinary support (such as callable capital). The three-notch cap on the ratings uplift is based on the above-mentioned risks. But it is also grounded in the uncertainty about the sovereign shareholders' willingness to make the payment of capital when called.
It is therefore possible that the destiny of the so-called Brexit bill could provide some pointers on how willing sovereign shareholders might be to support an MLI through capital calls. Capital calls would probably only ever occur if the MLI's financial performance had been weak for such an extended period of time that its capital base was severely eroded. At that point, the prestige and possibly also the policy role of the MLI would likely have declined, just as the policy role of the EU had declined in the eyes of the majority of British voters. Should the U.K. take a hard line and outright reject even those financial obligations that appear well justified, we might take this as an indication of how the U.K. (or other governments) might act in the case of a capital call.
The parallels between callable capital and the U.K. liabilities upon exiting the EU nevertheless have their limits. MLIs' articles of agreement usually describe the capital call process in general terms. The liabilities to be presented to the U.K., on the other hand, are likely to be based on ad hoc considerations. The presence of agreed broad rules could therefore make the attempt to avoid payment less likely in a capital call situation. The upcoming Brexit bill experience could therefore overstate the risks to capital calls not being heeded.
On the other hand, capital calls are designed to be issued to all sovereign shareholders at the same time. This may lead some sovereigns to wait and see whether fellow shareholders also pay. Caught in a "prisoners dilemma" situation, sovereign shareholders might be tempted to withhold payment if they observe that some of their peers do not make on-time payments in line with the capital call. Therefore, unwilling sovereigns could under certain circumstances hide behind the inaction of their peers. That could more easily justify avoiding payments to what may be perceived as a troubled supranational. This collective action problem does not exist in the Brexit situation. The Brexit bill experience could therefore understate the risks to successful capital calls. All the more so as the potential payments related to Brexit may be part of a wider trade-off, where the U.K. might expect to benefit from other concessions should it behave constructively toward the EU's financial demands. No comparable offsetting benefits are likely to exist for sovereign shareholders in the case of MLI capital calls.
It is therefore not immediately obvious whether the risks to a capital call not being respected by sovereign MLI shareholders is smaller or larger than the risk of the U.K. repudiating what seem to be reasonably established obligations.
A constructive resolution of the Brexit bill controversy conducted in good faith on both sides of the bargaining table could provide us with reassurances about the likelihood of capital calls being successful, should they ever occur. Such an outcome would therefore also support our current approach, where callable capital can provide substantial uplift to the rating. Conversely, an acrimonious breakdown of attempts to forge an agreement on the Brexit bill might lead us to reconsider the extent of ratings support provided by callable capital.
Who's at risk
It is too early to speculate about what turn the Brexit negotiations will take. Talks have not yet begun. S&P Global Ratings does not take a view and does not have any preference about how the U.K. government should respond to the presentation of a Brexit bill, when it is presented.
But given the short period of time available for Brexit negotiations (Article 50 of the EU Treaty sets a cap of two years), it is not too early to consider potential implications should the talks about the Brexit bill indeed end in acrimony and repudiation.
Should we conclude that the capital calls in general were compromised by such an acrimonious breakdown of Brexit talks, in principle we could review a moderate number of MLI ratings if they benefit from ratings uplift above the SACP due to extraordinary shareholder support. Five rated MLIs currently benefit from a ratings uplift due to callable capital (European Investment Bank, Inter-American Development Bank, Council of Europe Development Bank, African Development Bank, and Eurofima).
Such a review of our approach to callable capital could also be furthered by our observation that the remaining 27 EU members retreat voluntarily from what appear to be legitimate EU financial receivables against the U.K. This turn of events could signal that EU members may readily subordinate unenforceable financial obligations under political convenience. We believe that such an extreme collapse of Brexit discussions or a rapid surrender of the EU member sovereigns are very unlikely events, albeit not inconceivable.
One supranational rating that could come under downward pressure is the International Finance Facility for Immunisation (IFFIm, AA/Negative/A-1+). Like the EU, IFFIm fully depends on its sovereign members' annual contributions. Unlike the EU, which has significantly negative net assets, IFFIm had positive net assets as of year-end 2015. However, it accounts future donor payments as assets and half of those are scheduled to come from the U.K. IFFIm's equity could therefore shrink or become negative should the U.K.'s future donations be cancelled. More importantly it could also face mounting difficulties paying creditors after using its liquidity reserve (internal rule of minimum 12 months' worth of debt repayments), IFFIm has been providing funding for Gavi, the vaccine alliance, with the aim of frontloading vaccinations in developing economies. The bonds issued by IFFIm will be serviced through promises by nine donor countries to provide annual grants up to 2030. The U.K. is by far the largest contributor, accounting for 50% of the total. Should we observe that the U.K. will reject the full service of what we consider legitimate obligations towards the EU, an institution with a much more significant policy role than IFFIm, we could reassess our approach to rating IFFIm. Currently, we equalize the probability of the grants being paid as scheduled with the U.K.'s own sovereign rating. This means that we think the grant payment is currently equally as likely as the government paying its own senior unsecured debt. That assumption may not withstand observed U.K. resistance to paying its EU obligations.
We believe that the departure of the U.K. from the EU is owed to idiosyncratic political factors. We therefore do not take it as a precursor of the U.K., or other shareholders, departing from other supranationals. Should we see, however, that against our expectation, the number of sovereigns departing from one or several supranational organizations proliferate, we could reassess the policy role of affected MLIs, potentially exerting downward pressure on the ratings of affected institutions.