DBRS Confirms Cyprus at B (low), Stable Trend

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

At B (low), Cyprus’ ratings reflect the depth of Cyprus’ challenges and continued heavy reliance on external funding. Fiscal performance has exceeded expectations, and Cypriot authorities have successfully reformed domestic bankruptcy and foreclosure laws. This has enabled a material improvement in the debt profile and the government’s liquidity position, which benefits from ECB policies. However, parliamentary opposition has resulted in delays in enacting critical reforms. Effective restructuring of non-performing loans, now 157% of GDP, is crucial. A deep decline in property prices from current levels could pose significant challenges for the banks. Initial signs of economic stabilization are emerging, but the recovery remains reliant on external demand.

Continued strong economic and fiscal performance could lead to an upgrade. Accelerating progress on NPL resolution, privatization and efforts to encourage foreign investment could also provide support to the ratings. Additional efforts to extend the debt maturity profile and limit gross financing needs in the post-program period are also likely to have a positive impact. On the other hand, a prolonged period of weak growth, particularly if combined with fiscal policy slippages or additional bank support 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 creditworthiness. Though direct financial linkages have been significantly reduced, developments in Greece could also have an impact.
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 eurogroup/IMF program thus far, Cyprus is unlikely to need the full amount of support available under its existing program.

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. The declining ruble and Russian recession have had a significant impact on overall tourism receipts, but this has been partially offset by increased tourism from the UK and other countries. 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 could 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 of the gas sector could nonetheless be affected by relations with Turkey.

In spite of these strengths, Cyprus faces several near-term challenges. General government debt is expected to peak at 108% of GDP next year. Although the fiscal adjustment appears largely complete at this stage, continued fiscal discipline and stronger economic growth will be essential to bring debt down to more manageable levels over time. Gross financing requirements through mid-2016 should be comfortably met through official financing, and the government hopes to take advantage of lower market interest rates to extend debt maturities and minimize financing needs in the post-program period (2016-18). A prolonged deterioration in market conditions could present significant challenges given Cyprus’ heavy reliance on external funding.

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.

Cyprus’ small and relatively undiversified economy will remain heavily 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 important, though additional shocks from Europe could also have negative effects on Cyprus.

Notes:
If there is a change in the ratings or trends for EU credits, the Lead Analyst summarizes the main points of the RC discussion here. This is not required for non-EU credits.

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: Roger Lister
Initial Rating Date: 12 July 2013
Most Recent Rating Update: 5 December 2014

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