DBRS Confirms Cyprus at B (low), Stable Trend

DBRS, Inc. (DBRS) has confirmed the long-term foreign and local currency issuer ratings for the Republic of Cyprus at B (low). The Republic’s short-term foreign and local currency issuer ratings have been confirmed at R-5. The trend on all ratings remains Stable.

The confirmation of Cyprus’ ratings reflects DBRS’ view that near-term default risks remain contained due to strong implementation of the troika supported adjustment program. Cypriot authorities have demonstrated a strong commitment to the program, and economic and fiscal performance has exceeded expectations. 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 developments. Meanwhile, delays in the resolution of non-performing loans (NPLs) could reduce recovery values and add to the ultimate cost of bank restructuring.

Timely completion of upcoming program reviews combined with continued strong economic and fiscal performance could lead to an upgrade. Further action to strengthen Cyprus’ insolvency framework and aid the resolution of NPLs would also lend support to the rating. On the other hand, a prolonged period of stagnation, 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.

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 business center and tourist destination. Support from EU partners helps to enhance growth prospects, as regular EU budget transfers and long-term infrastructure financing from the European Investment Bank help to increase investment. Moreover, the €10 billion program agreed with the European Commission, European Central Bank and International Monetary Fund in 2013 has cushioned the impact of the financial crisis and recession and given Cypriot authorities space to tackle fiscal challenges. 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 bank 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 appeared to be less sensitive to economic cycles, and growth in Russian tourism in Cyprus has 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.

Within the next decade, 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 110% 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. The European Commission expects debt to peak at 115% of GDP next year, and 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. The government intends to focus additional fiscal measures 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.

Private sector debt ratios are also 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, domestic savings, and 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 Europe could also have negative effects on Cyprus.

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, and 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: 27 June 2014

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