DBRS Upgrades Cyprus to B, Stable Trend

DBRS, Inc. has upgraded the long-term foreign and local currency issuer ratings for the Republic of Cyprus from B (low) to B. DBRS has upgraded the short-term foreign and local currency issuer ratings from R-5 to R-4. The trend on all ratings is Stable.

The upgrade reflects DBRS’s view that strong fiscal performance and signs of economic stabilization have helped to ease near-term concerns regarding the fallout from the financial crisis. Cypriot authorities have demonstrated a strong commitment to the troika-supported adjustment program, and available official financing exceeds Cyprus’ needs. Nonetheless, Cyprus’ B ratings underscore the depth of Cyprus’ challenges and continued need for external support. Cyprus remains vulnerable due to high levels of debt, relatively high real interest rates and reliance on external demand to fuel growth.

Improvements in fiscal management and in debt and liquidity are the main factors driving the upgrade. Sustained economic and fiscal outperformance could lead to further upward pressure on the ratings. Accelerating progress on the resolution of non-performing loans, on privatization and on steps to encourage foreign investment could enhance growth prospects and also provide support to the ratings. On the other hand, a prolonged period of weak growth, particularly if combined with fiscal policy slippages and higher financing needs, 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 prospects for growth and investment in tourism, financial services and the energy sector.

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 and IMF program thus far, Cyprus is expected to forgo a portion of the support available under its existing program.

Cyprus’ low tax environment remains attractive to foreign corporations. Business owners from Russia and other Eastern European 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 largely been 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.

Over the next few decades, exploitation of offshore natural gas deposits could provide a major new source of income for the island economy. Although exploration efforts have slowed due to global market conditions, proven gas reserves should still bring in a considerable amount of new revenue for the government. If managed prudently, the associated financial inflows could help to significantly reduce Cyprus’ exposure 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 appears to have peaked at 108.2% in 2014. 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 can be comfortably met through official financing, and the government has taken 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 nonetheless 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, albeit at a more moderate pace, 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:

The main issues discussed during the rating committee included: the stabilization of the economy and prospects for a sustained recovery; fiscal performance and structural fiscal reforms; the Eurogroup and IMF support program; debt management operations and financing needs; financial sector stability and the removal of capital controls; the impact and resolution of non-performing loans; and the impact of external developments, particularly in Greece, Russia and Turkey.

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.

DBRS does not typically accept editorial changes other than to correct for factual, accuracy and/or to remove confidential, material non-public, or sensitive information that might otherwise be inadvertently disclosed.

Lead Analyst: Thomas R. Torgerson
Rating Committee Chair: Roger Lister
Initial Rating Date: 12 July 2013
Most Recent Rating Update: 5 June 2015

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