DBRS Upgrades Republic of Cyprus to B (low), Stable Trend

DBRS, Inc. (DBRS) has upgraded the long-term foreign and local currency issuer ratings for the Republic of Cyprus from CCC to B (low) with Stable trends. The Republic’s short-term foreign and local currency issuer ratings have been confirmed at R-5 with Stable trends.

The upgrade reflects DBRS’ view that near-term default risks have eased considerably with the authorities’ strong implementation of their macroeconomic adjustment program, progress on stabilizing the financial system, and the economy’s outperformance relative to earlier program forecasts. Nonetheless, at B (low), the rating underscores the depth of Cyprus’ challenges and heavy reliance on EU funding. High public sector debt combined with elevated real interest rates raises significant questions regarding debt sustainability. The process of deleveraging across the public, corporate and household sectors could be prolonged, leaving the economic recovery heavily reliant on external factors. Meanwhile, delays in the resolution of non-performing loans (NPLs) could reduce recovery values and add to final bank recapitalization costs.

Continued outperformance relative to program targets combined with strong and durable support from external demand could lead to upward pressure on the Republic’s ratings. Investment into the gas sector combined with the adoption of a sound fiscal framework that utilizes additional revenues to strengthen the sovereign balance sheet could also have positive effects. On the other hand, a prolonged period of shrinking output, particularly if combined with fiscal policy slippages or additional bank rescue costs, could result in downward pressure on the ratings. External factors, including political developments between Cyprus and Turkey and between the EU and Russia, could also have an impact on Cyprus’ creditworthiness.

Membership in the European Union (EU) and Eurozone grants several key advantages which underpin the Republic’s ratings. Cyprus joined the EU in 2004 and adopted the euro in 2008. Policy measures adopted in the process of EU accession and more recently as part of the economic adjustment program have helped to bolster public finances, strengthen domestic institutions, and enhance the attractiveness of Cyprus as a tourist destination. Financial support from EU partners helps to enhance growth prospects, particularly the 2013 EUR 10 billion support program agreed with the European Commission, European Central Bank and International Monetary Fund. Regular EU budget transfers and long-term infrastructure financing from the European Investment Bank also provide support. Given the Republic’s strong performance under the troika program thus far, EU partners may be willing to provide additional financing to Cyprus should the need arise.

Cyprus’ low tax environment remains attractive to foreign corporations. Business owners from Russia and other former CIS countries continue to incorporate in Cyprus for tax and other reasons in spite of the losses imposed on foreign depositors in 2013. Although Cyprus’ advantages are not unique and could be eroded by external competitors or by regulatory changes in creditor countries, DBRS expects the business services sector to remain an important source of employment and income for the Cypriot economy.

Cyprus’ geographic location makes the island a relatively convenient summer tourist destination for Europeans. Rising household incomes in Eastern Europe should continue to provide a stable source of growth in tourist arrivals. Higher income Russian tourists have thus far proven less sensitive to economic cycles, and growth in Russian tourism in Cyprus has far exceeded the pace of Russian economic growth. Tourism will remain highly seasonal and vulnerable to economic downturns, but focused and pragmatic public and private sector efforts to expand the island’s appeal could generate long-term benefits.

Also in the long-term, exploitation of offshore natural gas deposits should provide a major new source of income for the island economy. The government estimates that current proven reserves are likely to bring in net revenue of close to EUR 20 billion over the next 20 years (over 120% of 2013 GDP). If managed prudently, the associated financial inflows could help to significantly reduce Cyprus’ vulnerability to shocks. In addition, related investment and lower domestic energy costs could have ancillary benefits for the Cypriot economy. The pace of development in the gas sector could nonetheless be affected by relations with Turkey.

In spite of these strengths, Cyprus faces several near-term challenges. Private sector debt ratios are at historically high levels and suggest that growth will be constrained by further deleveraging. Household and corporate balance sheets have been damaged in the crisis, including through the bail-in of uninsured depositors. Real estate prices are still declining and the ultimate impact of the decline on household wealth and on bank solvency is not yet clear. Financial institutions will need to significantly reduce outstanding domestic credit or identify significant new sources of funding.

Consequently, Cyprus’ small and relatively undiversified economy will remain highly dependent on external demand for the foreseeable future. DBRS expects only gradual improvements from efforts to extend the tourist season and remains concerned that competition from other Mediterranean locations may dampen growth in the sector. If growth in tourism and business registrations slows significantly, the economy could face gradually declining output for years to come as the domestic deleveraging process continues. Russian demand is particularly critical, though additional shocks from Greece or elsewhere in Europe could also have negative effects on Cyprus.

Fiscal and debt challenges are also significant. The European Commission expects debt to peak at 126% of GDP next year, but this assumption is highly sensitive to growth and fiscal projections. Although financing requirements through early 2016 are being met through official financing and privatization revenue targets, Cyprus is likely to require significant new external financing to meet expected debt redemptions after the program concludes. Current estimations of the output gap suggest that Cyprus will need 3-4% of GDP in additional fiscal adjustments to attain structural fiscal balance in the medium term. The government intends to focus on expenditure cuts and has thus far demonstrated strong capacity to control spending. Nonetheless, specific cuts have not been identified and could be challenging to implement in the context of a weak economy. Furthermore, if estimations of the output gap prove overly optimistic, additional adjustment could be required.

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 Ministry of Finance, Central Bank of Cyprus, Statistical Service of the Republic of Cyprus, IMF, European Commission, ECB, Bank of Cyprus. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

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

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

Lead Analyst: Thomas R. Torgerson
Rating Committee Chair: Alan 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.