DBRS Assigns CCC Ratings to Cyprus, Negative Trend

DBRS, Inc. (DBRS) has today assigned long-term foreign and local currency issuer ratings for the Republic of Cyprus at CCC with Negative trends, and short-term foreign and local currency issuer ratings at R-5 with Stable trends. The ratings reflect DBRS’s view that Cyprus’ creditworthiness is impaired by (i) the deterioration in the country’s economic and fiscal outlook, which DBRS believes could undermine the government’s efforts to stabilize the public debt ratio, and (ii) the possibility that Cyprus’ medium-term funding program could be constrained by the persistence of a large debt burden.

The Negative trend on the long-term ratings reflects DBRS’s view that macroeconomic stability has yet to be restored. There is a high degree of uncertainty regarding the growth outlook due to the ongoing restructuring of the financial system, adverse effects from fiscal consolidation, declining property prices, and weak external demand. Of particular concern in the near term is the uncertainty due to the possibility of greater capital flight in the event of a lifting of capital controls. Should capital outflows accelerate, this could adversely affect banks’ funding needs and the flow of credit.

The CCC ratings are underpinned by the March 2013 Economic and Financial Assistance support programme to cover Cyprus’ funding needs from 2013 to 2016. The ratings are further underpinned by the country’s low tax environment and by the presence of gas reserves which could provide a boost to government revenues and growth over the long-term.

DBRS believes that the signing of the Memorandum of Understanding (MoU) between the Cypriot government, the European Central Bank, the European Commission (EC) and the IMF constitutes a positive development. According to the MoU, the external creditors will provide Cyprus with EUR10 billion (55% of GDP) in funding over the next three years, and this should ensure that Cyprus will meet its financing needs through the first quarter of 2016. Under the program, debt stabilization relies on the combination of a return to growth in 2015, and the running of large primary surpluses from 2016 onwards. However, DBRS cautions that there are substantial downside risks to the assumption that the country will return to growth in 2015. This return to growth is expected to be driven by a rebound in private consumption and investment, as well as by a considerable rebalancing of the external sector. Should this growth not materialize, and if primary surpluses are not generated, this could result in debt-to-GDP peaking at a higher level. As a result, reducing the debt from a peak of 126% of GDP in 2016 to 105% of GDP by 2020, as anticipated in the program, could prove challenging.

Cyprus’ medium-term growth prospects will likely be hampered by the rebalancing of the economy away from the sectors which spurred growth over the last decade. These are namely real estate (12% of the economy), financial sector (9%) and public administration (22%). DBRS thus believes that over the medium-term, average annual economic growth could be lower than the 1.9% assumed in the program. Achieving and maintaining a primary balance of 4% of GDP over the medium-term could also prove ambitious, as it requires a reduction in government spending from 46.3% of GDP in 2012 to an average of 42.2% from 2017 until 2020, the final year of the MoU.

External sustainability is also likely to come under pressure as the economy rebalances away from the exports of financial services, which between 2004 and 2008 accounted for an average 65% of net services exports. Over the past decade, Cyprus’ dependence on imports of energy and capital goods employed in the construction industry was partially offset by the positive contribution from the services balance. However, although the weak economic environment in the coming years will likely reduce non-energy imports, the downsizing of the domestic financial sector will likely restrict the contribution from service exports. As a result, DBRS views the EC and IMF expectation of a narrowing of the current account deficit from 6.5% of GDP in 2012 to 2% in 2013 and 1% in 2016 as unlikely.

DBRS believes that despite the stabilizing influence of the MoU, financial system liquidity and consumer and investor confidence could be negatively affected by recent program measures. Both domestic and foreign private sources are to contribute EUR13 billion to the financing package through the following measures: (i) a debt exchange of EUR1 billion of bonds held under domestic law, (ii) the involvement of the private sector in the restructuring of the country’s two largest banks, including shareholders, bondholders, and holders of uninsured deposits, and (iii) the renegotiation of the terms of the EUR2.5 billion loan from the Russian Federation. DBRS classifies the debt exchange as a default and these arrears have now been cleared. This, together with the involvement of the private sector in the restructuring of the banking sector and the other burden-sharing measures, are positive for public debt sustainability. Nevertheless, these actions are likely to have impaired Cyprus’ access to foreign private funding, and constitute credit impairment.

The trend on the long-term ratings could be moved to Stable if macroeconomic stability is restored, downside risks to growth diminish, and any additional bank recapitalization needs are manageable. Conversely, the ratings could be lowered if the recession is significantly deeper than currently envisaged, jeopardizing fiscal targets. The ratings could also come under downward pressure if a removal of capital controls results in an acceleration of capital flight, putting pressure on bank balance sheets.

Notes:

All figures are in euros (EUR) unless otherwise noted.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales.

The sources of information used for this rating include the IMF, the European Commission, the European Central Bank, Eurostat, the Ministry of Finance of the Republic of Cyprus, the Central Bank of Cyprus, the Statistical Office of the Republic of Cyprus, Haver Analytics, DBRS. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer and did not include participation by the issuer or any related third party.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: Fergus McCormick
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 12 July 2013
Most Recent Rating Update: 12 July 2013

For additional information on this rating, please refer to the linking document under Related Research.