DBRS Upgrades Republic of Cyprus to BB, Trend Remains Positive

DBRS Ratings Limited (DBRS) upgraded the Republic of Cyprus’s Long-Term Foreign and Local Currency – Issuer Ratings from BB (low) to BB and maintained the Positive trend. DBRS also confirmed the Short-Term Foreign and Local Currency – Issuer Ratings at R-4 and changed the trend to Positive from Stable.

KEY RATING CONSIDERATIONS

The upgrade is driven by the decline in Cypriot banks’ non-performing loans (NPLs) and Cyprus’s better-than-expected fiscal performance. The banking system’s stock of NPLs fell by 14% in 2017. From their peak in February 2015 to December 2017, total NPLs fell by 28%. Also in 2017, the fiscal surplus came in at 1.8% of GDP, above an already upwardly-revised target of 1.0%. A larger fiscal surplus, together with strong growth and early debt repayments, contributed to a significant fall in Cyprus’s government debt-to-GDP ratio from 106.6% in 2016 to 97.5% in 2017. Improvements in DBRS’s building blocks of “Monetary Policy and Financial Stability”, “Fiscal Management and Policy”, and “Debt and Liquidity” were the key factors for the rating upgrade.

The Positive trend reflects DBRS’s view that Cyprus’s solid economic and fiscal performances are likely to be sustained, contributing to the downward trajectory of the government debt ratio after an increase in 2018. After a stronger-than-expected 3.9% in 2017, real GDP growth is forecast at 3.8% in 2018 and 3.6% 2019. Moreover, the forecast for the fiscal surplus over the next two years is 1.7%, with the primary surplus above 4%, among the highest in the European Union (EU). NPLs remain very high and a major vulnerability for Cypriot banks, but DBRS expects NPLs to continue to fall, driven by measures already in place, a policy strategy recently presented, and improving economic conditions.

RATING DRIVERS

An upgrade in the ratings would come from Cyprus’s demonstration to sustain healthy economic growth and a sound fiscal position, which would support the downward trajectory in the public debt ratio. Important progress on privatisations could also put upward pressure on the ratings. Moreover, Cyprus’s ability to significantly reduce vulnerabilities in the private sector, including a material reduction of non-performing loans, would be positive for the ratings. However, a period of significantly weak growth, combined with large fiscal imbalances, could lead to a change in the trend back to Stable. A reversal of the downward trajectory in NPLs could also be negative.

RATING RATIONALE

The Reduction of High NPLs and Deleveraging of the Private Sector Continue to Progress

After reaching a peak at the beginning of 2015, the stock of NPLs has been declining largely driven by the non-financial corporations (NFCs) sector. Corporate NPLs account for 45% of total NPLs in the system. Between April 2015 and December 2017, the stock of corporate NPLs fell by 36%, in part helped by loan restructurings of large NFCs. The decline in household NPLs, which account for 53% of total NPLs, has been less impressive. Since their peak in February 2015, the stock of household NPLs has fallen by 16%. The banking system’s coverage ratio (NPLs covered by provisions) has also increased, from 38.8% in June 2016 to 47.3% in December 2017, in line with the EU average.

Despite the improvement in the reduction of NPL stocks, NPL ratios remain high as outstanding loans have decreased. NPLs for the banking system were 42.5% of total loans in December 2017, compared to the 49.0% peak in May 2016. The 90-days past due loans ratio was 32.6%, down from 37.5% in the same period. Very high NPLs, which increased significantly during the severe crisis in 2012-2014, remain the main risk to financial stability and a major rating challenge for Cyprus.

Important efforts to speed the resolution of legacy NPLs are ongoing. The three core domestic banks have set up independent debt servicing companies with foreign debt specialists. Moreover, the government recently presented a three-pillar policy strategy for the reduction of NPLs, to be fully implemented in 2018 and focused on: 1) strengthening the effectiveness of the legal framework adopted in 2015, to tackle deficiencies on various laws and foster the development of a secondary market for NPLs; 2) addressing NPLs related to retail mortgages and SME lending backed by main residence as collateral, through burden sharing between stakeholders and state support; and 3) the sale of Cyprus Cooperative Bank, which the government as the major shareholder has initiated. These efforts, together with the economic recovery, declining unemployment, and rising house prices, bode well for the further reduction in NPLs.

High indebtedness in the private sector remains an additional risk, but the deleveraging process continues. The decline in household debt has been notable, reaching 109% of GDP in Q4 2017 down from a peak of 131% in Q1 2015. NFC debt, which in part reflects special purpose entities (SPEs) of foreign-financed shipping companies with international operations, has fallen from a peak of 229% in Q1 2015 to 207% in Q4 2017 (130% excluding SPEs). Deleveraging is taking place through cash repayments, debt-for-asset swaps and loan write-offs.

The Public Debt Ratio Is Set to Fall and The Sound Fiscal Performance to Be Maintained

A still high government debt ratio is another rating challenge, but it is expected to resume its decline after an increase this year. Cyprus’s government debt-to-GDP ratio peaked at 107.5% in 2015. In 2017, following early loan repayments to the Central Bank of Cyprus and the IMF, the debt ratio fell below 100%. In 2018, the ratio will be impacted by the issuance of domestic bonds for €2.35 billion. The government deposited the funds with Cyprus Cooperative Bank (CCB) to rebuild confidence in the bank and facilitate its sale. As a result, the forecast for the debt ratio this year is 105.6%. The ratio is then projected to fall to 100% in 2019, and 94.6% in 2020, supported by solid growth and large primary surpluses. While additional fiscal burden from the banking sector cannot be ruled out, DBRS views favourably the government’s actions to address the challenges in the sector.

Although debt dynamics remain vulnerable to adverse shocks, public debt management has been effective. This has resulted in a favourable debt profile that reduces refinancing risks and supports Cyprus’s ratings. A liquidity buffer covers 9-month funding needs, and the average maturity of government debt was 8.0 years in April 2018. Floating-rate debt increased in recent years but this mainly relates to official loans, which account for 54% of total debt. Moreover, the weighted average cost of debt has declined, reaching 2.2% 2017 compared to a peak of 4.2% in 2012.

A sound fiscal position is expected to be maintained, supporting the ratings. Cyprus accomplished the consolidation of its budget position in a relatively short time. Despite the fiscal impact from the policy strategy for the reduction of NPLs, the budget position is expected to remain in a healthy surplus above 1.5% over the next four years, supported by strong revenues and contained expenditure. The government is also aiming to maintain a small structural surplus, above its medium-term objective of a structural balance. Adopted reforms to strengthen fiscal management, including the reform to the wage indexation system, together with expenditure ceilings embedded in the Fiscal Responsibility and Budget Law, are expected to reinforce the sustainability of public finances.

Strong Economic Growth is Being Supported by Domestic and External Demand

Cyprus’s attractiveness as a business services centre, a tourist destination, and a shipping centre supports the ratings. The tourism sector benefits from a market of wealthy economies. It also continues to diversify into new markets and products, making it more resilient. The sector has gained significantly from the extension of the tourist season in 2016 and the increasing hotel capacity. This saw tourist arrivals rise by 20% in 2016 and 15% in 2017. Nevertheless, the small size of its service-driven economy exposes Cyprus to adverse changes in external demand and poses a challenge to the ratings.

After gathering momentum in 2017, Cyprus’s GDP growth is expected to remain robust. Forecasts point to growth close to 4% this year and next, driven by important investment projects, exports, and consumption. Growth has been broad-based, with tourism, shipping, professional services, manufacturing, and construction all making a contribution. Downside risks to the outlook are mainly related to a less favourable external environment and geopolitical risks. Upside risks include the broader economic impact of a large casino-resort project, currently under construction.

Cyprus’s current account remains in deficit and its net external liability position is relatively large, posing a challenge to the ratings. After improving significantly in recent years, Cyprus’s current account deficit has deteriorated. It reached 6.7% of GDP in 2017. Although the services balance remains in large surplus, the goods trade deficit has widened. Overall, Cyprus’s current account is influenced by large exports and imports of transport equipment related to investment (mainly ships). Cyprus’s negative net international investment position (NIIP) has improved but also remains high, at 120.4% of GDP in 2017. Nevertheless, the deficit and the negative NIIP reflect in large part activities in the international business centre and SPEs operating in the shipping sector, with limited links to the domestic economy. Excluding SPEs, the current account deficit was 1.5% and the negative NIIP was 40.8% in 2017.

The Recent Presidential Election Result Provides A Solid Mandate for Policy Continuity

Cyprus benefits from a stable political environment and institutions, and the government remains committed to addressing the country’s challenges. This, together with Cyprus’s eurozone membership, support its ratings. The re-election of President Anastasiades in February 2018, with 56% of the votes, gives him a strong mandate for a second consecutive term. DBRS expects continuity on fiscal policy and the debt management strategy, and progress on the policy efforts for the reduction of NPLs. However, the government lacks a majority in the House of Representatives. This has resulted in delays in adopting reforms and is likely to remain a challenge for the government’s policy agenda.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the BBB (high) – BBB (low) range. Additional considerations factoring into the Rating Committee decision included: A relatively limited capacity for external adjustment within the Euro Area given the size of the Cypriot economy, still high levels of private sector debt, and the legacy effect of the losses imposed on depositors in 2013. The main points discussed during the Rating Committee include non-performing loans, the performance of the banking sector, the fiscal position, the debt ratio, and the economic outlook.

KEY INDICATORS

Fiscal Balance (% GDP): 1.8 (2017); 1.7 (2018F); 1.7 (2019F)
Gross Debt (% GDP): 97.5 (2017); 105.6 (2018F); 100.0 (2019F)
Nominal GDP (EUR billions): 19.2 (2017); 20.0 (2018F); 20.9 (2019F)
GDP per Capita (EUR): 22,360 (2017); 23,132 (2018F); 24,028 (2019F)
Real GDP growth (%): 3.9 (2017); 3.8 (2018F); 3.6 (2019F)
Consumer Price Inflation (%): 0.7 (2017); 0.5 (2018F); 1.0 (2019F)
Domestic Credit (% GDP): 321.1 (Sep-2017)
Current Account (% GDP): -6.7 (2017); -7.1 (2018F); -7.8 (2019F)
International Investment Position (% GDP): -120.4 (2017)
Gross External Debt (% GDP): 557.2 (2017)
Governance Indicator (percentile rank): 78.37 (2016)
Human Development Index: 0.84 (2015)

Notes:
All figures are in EUR unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Fiscal balances include one-offs. Forecasts based on the 2018-2021 Stability Programme. A large part of non-financial corporate debt relates to ship owning companies with international operations. The current account balance, external debt and the net international investment position include special purpose entities (SPEs) of shipping companies and financial companies. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/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 at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include Ministry of Finance, Public Debt Management Office, Central Bank of Cyprus, Statistical Service of the Republic of Cyprus, Bank of Cyprus, Hellenic Bank, Cooperative Bank of Cyprus, European Commission, European Central Bank (ECB), Eurostat, IMF, World Bank, UNDP, Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be 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 historical default rates published by the European Securities and Markets Authority (“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 and US regulations only.

Lead Analyst: Adriana Alvarado, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global Financial Institutions Group and Sovereign Ratings
Initial Rating Date: 12 July 2013
Last Rating Date: 1 December 2017

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