DBRS Confirms Republic of Cyprus at B, Stable Trend

DBRS Ratings Limited (DBRS) has confirmed the Republic of Cyprus’s long-term foreign and local currency issuer ratings at B and the short-term foreign and local currency ratings at R-4. The trend on all ratings is Stable.

The ratings reflect Cyprus’s Eurozone membership, which has ensured financial support, as well as its attractiveness as a business services centre and a tourist destination, the solid fiscal performance achieved under the economic adjustment programme, and its favourable public debt maturity profile. However, the ratings also underscore the depth of Cyprus’s challenges, given its high levels of public and private sector debt, sizable non-performing loans, persistent external imbalances and the small size of its relatively undiversified economy.

As economic conditions stabilised in 2015, output returned to growth. The recovery appears likely to strengthen gradually, supported by tourism, stabilisation in the housing sector and improving conditions in the labour market. The Stable trend reflects DBRS’s view that the economic recovery, while expected to be broadly steady, could face some risks in the near term given its reliance on external demand. Conditions in the global economy could prove less supportive and volatility in financial markets could intensify. In particular, a UK vote to leave the EU could affect the recovery of the Cypriot economy given its strong trade and financial links to the UK.

Cyprus benefits significantly from its membership in the Eurozone. Policy measures implemented by Cyprus in the process of EU accession in 2004 and adoption of the Euro in 2008, and more recently, under the economic adjustment programme, have helped strengthen domestic institutions and enhance Cyprus’s attractiveness as a business centre and tourist destination. EU budget transfers and long-term infrastructure financing from the European Investment Bank also contribute to investment. Moreover, in March 2016, Cyprus concluded the three-year programme agreed with the European Commission, the European Central Bank and the IMF. The IMF contributed €1 billion, while the EU provided €6.3 billion of the €9 billion initially agreed. The programme allowed Cyprus to consolidate its public finances and restructure its banking sector.

The attractiveness of Cyprus as a business services centre is not only supported by strengthened institutions and policies, but also by its low corporate tax environment. Although Cyprus’s advantages 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 has also taken advantage of its geographic location that makes the island an attractive tourist destination for Europeans.

Cyprus’s robust fiscal performance in recent years provides additional support to the ratings. The government achieved a relatively quick improvement in the budget position, with the headline fiscal deficit declining from 5.8% of GDP in 2012 to 1.0% in 2015 and the primary deficit shifting to a surplus of close to 2%. Fiscal management has also been strengthened, which together with some privatisations, should help maintain the fiscal adjustment. The fiscal position is expected to continue to improve over the coming years.

Cyprus’s public debt maturity structure is also favourable. The government has benefited from lower market interest rates and extended debt maturities, thus reducing refinancing risks. The average debt maturity was 8.5 years at the end of 2015. In particular, ESM loans – with a weighted average maturity of nearly 15 years - are not set to be repaid until 2025.

Nevertheless, Cyprus faces several credit challenges. General government debt is estimated to have peaked at 108.9% of GDP in 2015. 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. Moreover, a prolonged deterioration in market conditions could present significant challenges given Cyprus’s reliance on external funding.

Private sector debt ratios are also at historically high levels and suggest that growth will be constrained by deleveraging. Household and corporate balance sheets have been damaged in the crisis, through the bail-in of uninsured depositors and the fall in real estate prices. At the same time, Cypriot banks’ non-performing loans for households and corporations are extremely high, at around 55% of total loans, although important efforts have been taken to speed the resolution of NPLs.

Cyprus’s external imbalances pose another challenge. Although the current account deficit has narrowed significantly in recent years, to below 4% of GDP, a persistent current account deficit and a sizable net external liability position of almost 130% of GDP, together with reliance on external borrowing, leaves Cyprus exposed to external shocks.

Cyprus’s small and relatively undiversified economy is also expected to remain heavily dependent on external demand for the foreseeable future. Competition from other Mediterranean locations may dampen growth in the sector and additional shocks from Europe could also have negative effects. If growth in tourism and business registrations slows significantly, growth prospects could be affected, as the domestic deleveraging continues.

RATING DRIVERS
Upward rating action will depend on Cyprus’s ability to generate sustained economic growth and primary fiscal surpluses. The fiscal performance has been strong and the improvement should be maintained, supported by fiscal reforms adopted during the economic adjustment programme. Continued recovery of the economy and sustainability of the fiscal adjustment should improve the outlook for public debt dynamics. Stronger progress on the resolution of non-performing loans and on privatisation could also put further upward pressure on the ratings. However, a prolonged period of weak growth, particularly if combined with fiscal slippage and higher financing needs, could result in downward pressure on the ratings. External factors, including adverse political developments between Cyprus and Turkey and between the EU and Russia, as well as a UK vote to leave the EU, could also have an impact on the prospects for growth and investment in tourism, financial services and the energy sector. Such developments could also result in downward pressure on the ratings.

Notes:
All figures are in euro [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. These can be found on www.dbrs.com at:
http://www.dbrs.com/about/methodologies

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

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS’s outlooks and ratings are under regular surveillance.

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.

Ratings assigned by DBRS Ratings Limited are subject to EU regulations only.

Lead Analyst: Adriana Alvarado, Assistant Vice President
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer
Initial Rating Date: 12 July 2013
Last Rating Date: 4 December 2015

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