DBRS Morningstar Confirms Republic of Cyprus at BBB (low), Trend Changed to Positive

DBRS Ratings Limited (DBRS Morningstar) confirmed the Republic of Cyprus’s Long-Term Foreign and Local Currency – Issuer Ratings at BBB (low) and changed the trend to Positive from Stable. At the same time, DBRS confirmed the Republic of Cyprus’s Short-Term Foreign and Local Currency – Issuer Ratings at R-2 (middle) and changed the trend to Positive from Stable.

KEY RATING CONSIDERATIONS

The Positive trend reflects DBRS Morningstar’s view that the outlook for the downward trajectory in the public debt ratio has improved, driven by sustained robust economic growth, large primary surpluses and early debt repayments. While moderating, economic growth in Cyprus is projected at around 3% in 2019 and 2020, among the strongest in the Euro area. Cyprus’s fiscal position has also continued to improve, with the fiscal surplus reaching sizable levels, and the government is planning to repay the IMF loan in advance next year. The materialisation of fiscal risks could delay the reduction in public debt, but strong growth, together with large fiscal surpluses and early debt repayments, is still expected to contribute to the decline in the government debt-to-GDP ratio over the coming years. The improvement in DBRS Morningstar’s building block of “Debt and Liquidity” was the key factor for the trend change.

The BBB (low) ratings are supported by Cyprus’s solid budget position, its prudent public debt management framework, its Eurozone membership fostering sustainable macroeconomic policies, and its openness to investment encouraging a favourable business environment. Nevertheless, Cyprus also faces significant credit challenges related to sizable non-performing exposures (NPEs) in the banking sector and the economy, high levels of private and public sector debt, external imbalances, and the small size of its service-driven economy, which exposes Cyprus to adverse changes in external demand.

RATING DRIVERS

The ratings could be upgraded if healthy economic growth is sustained and the fiscal position remains sound, contributing to the downward trajectory in the public debt ratio. Further progress in substantially reducing banks’ NPEs and private sector debt, and the strengthening of the banking sector would also be positive for the ratings. However, the Positive trend could be changed back to Stable if growth weakens significantly and the fiscal position worsens substantially. A reversal of the downward trajectory in NPEs could also be negative for the ratings.

RATING RATIONALE

The Public Debt Ratio Is Resuming Its Downward Trend and The Fiscal Performance Remains Sound

After a large increase in 2018, the government debt-to-GDP ratio is expected to decline at a relatively rapid pace over the next years. The government’s support associated with the sale of Cyprus Cooperative Bank (CCB) impacted government debt in 2018. But the debt ratio is projected at 95.6% in 2019, according to the latest government forecasts, down from 100.6% in 2018. By 2021, IMF and European Commission projections point to a debt ratio well below 90%. The factors contributing to the rapid debt reduction are strong economic growth, large primary surpluses of around 5% of GDP, and early debt repayments. The government repaid the Russian loan in September 2019 and is looking to fully repay the IMF loan in advance in 2020.

Although debt dynamics are vulnerable to adverse shocks, particularly a materialisation of contingent liabilities, public debt management is prudent. This has resulted in a favourable debt profile that reduces refinancing risks. Debt maturities have been extended, with the average maturity of marketable government debt rising to 6.3 years in September 2019. A liquidity buffer covers at least 9-month funding needs. Moreover, the weighted average cost of debt has declined, reaching 2.2% in September 2019 compared to a peak of 4.2% in 2012. Debt is largely denominated in euros.

A sound fiscal position is expected to be maintained, contributing to the reduction of debt. Following the one-off negative effect related to the sale of CCB in 2018, which shifted the fiscal surplus into deficit, the government is targeting a surplus of 3.8% in 2019 and 2.7% in 2020, supported by strong revenues and contained expenditure. The government is also aiming to maintain a structural surplus, above its medium-term objective of a structural balance. Adopted reforms to strengthen fiscal management in recent years, including the reform to the wage indexation system, together with expenditure ceilings embedded in the Fiscal Responsibility and Budget Law, reinforce the sustainability of public finances.

Risks to the fiscal outlook include the pending Supreme Court ruling on the public sector wage cuts during the crisis and risks associated to the financial sector. While the government has started the gradual reversal of wage cuts, a court ruling against the government could lead to an immediate reversal, impacting fiscal accounts in the near term. Related to the financial sector and as part of the CCB transaction, an Asset Protection Scheme (APS) guaranteed by the state was created, increasing the government’s contingent liabilities. The APS will cover potential unexpected losses on certain assets acquired by Hellenic Bank. The government estimates that potential unexpected losses will not to exceed EUR 155 million (equivalent to 0.7% of GDP) over 12 years. Any calls on the APS guarantees would be covered by the state’s Asset Management Company without drawing on the budget.

The Cypriot Economy Continues to Perform Strongly

Cyprus’s economic growth remains strong, albeit moderating. Growth has been largely driven by private consumption and investment. It has also been broad-based, with construction, tourism, shipping, professional services, and manufacturing, contributing. Employment growth has been strong, the unemployment rate has fallen to 6.6% in September 2019 and wages are rising. This, together with low inflation, is supporting disposable incomes. Since 2015, annual real GDP growth has averaged 4.6%. And after posting a 4.1% in 2018, real GDP growth is projected at a more moderate but still robust 3.1% in 2019 and 2.9% in 2020 by the IMF. The deceleration this year largely reflects a less favourable external environment. In 2020, private consumption is expected to be weighed down by debt repayments and contributions to the new national health system, introduced in March 2019 and to be adjusted upwards from March 2020. Downside risks to the outlook are related to an even less favourable external environment and adverse developments in the financial sector, while upside risks include the broader economic impact from a large casino-resort, currently under construction, and other projects.

Cyprus’s capacity to grow has improved in recent years, with potential GDP growth rising close to 2.5%, according to IMF estimates. The recovery in investment has been a key driver of the improvement. Cyprus is an attractive business services centre, shipping centre, and tourist destination. The tourism sector is diversifying into new products and markets, making it more resilient. The expected exploitation of off-shore gas reserves represents another potential source of growth in the longer term. Nevertheless, the small size of its service-driven economy exposes Cyprus to adverse changes in external demand.

Risks to Financial Stability Have Declined But Remain Relatively High

High NPEs remain the main risk to financial stability in Cyprus. This weighs on DBRS Morningstar’s assessment of the Monetary Policy and Financial Stability building block. Cypriot banks’ NPEs declined materially in 2018. As reported by the Central Bank of Cyprus, the stock of the banking sector’s NPEs dropped from EUR 20.9 billion in December 2017 to EUR 10.4 billion in December 2018. The largest reduction in banks’ NPEs resulted from the resolution of state-owned Cyprus Cooperative Bank, which involved selling part of its assets to Hellenic Bank and effectively removed EUR 5.8 billion of NPEs from the Cypriot banking system. These NPEs are now in the state’s Asset Management Company (AMC) and expected to be disposed of over time. The government also strengthened the insolvency and foreclosure frameworks and the sales-of-loans law and adopted a law on securitisations in July 2018.

At the same time, Cypriot banks stepped up their efforts to reduce NPEs. Supported by the strengthened legal framework, Bank of Cyprus, the largest bank in the country, sold an NPE portfolio of EUR 2.7 billion in 2018. This follows Hellenic Bank’s NPE sale earlier in the year. Core domestic banks also set up independent debt servicing companies with foreign debt specialists. Together, the orderly liquidation of Cyprus Cooperative Bank and the banks’ sale of NPE portfolios almost halved the stock of the banking sector’s NPEs in 2018. From their 2015 peak to May 2019, the stock of NPEs is down by 65%.

So far in 2019, the reduction in NPEs has continued but it has been limited. In the year to May – the latest data available – the stock of NPEs has fallen by just over 1%. The total NPE ratio has remained at 31.0%, although down from a 49.0% peak in May 2016. In part, the still high ratio reflects the reduction in bank loan portfolios as households and businesses deleverage. The NPE reduction this year has been mainly organic, including through cash repayments, debt-for-assets swaps, and write-offs. By segment, the SME NPE ratio fell to 37.2% in May 2019 from 39.2% in December 2018, the large non-financial corporations NPE ratio declined to 18.1% from 19.0%, while the household NPE ratio has remained virtually unchanged at 37.7%.

In September 2019, the government started to implement its social scheme (‘ESTIA’), a main pillar of its NPE reduction strategy aimed at tackling NPEs related to retail mortgages, which account for about half of total NPEs. The scheme has been designed to help only eligible households repay their loans, and thus exclude strategic defaults. But the scheme seems unlikely to lead a material reduction of NPEs in the Cypriot economy, as the level of participation has been low so far. The scheme is now expected to address well below the up to EUR 3.4 billion of NPEs initially estimated by the government that could potentially be eligible, a large part of which are within the AMC.

Looking ahead, DBRS expects further progress in NPE reduction to be largely driven by the banks’ efforts. Sales of banks’ NPE portfolios are expected next year. Cypriot banks remain profitable, and their capital levels and loss loan provisioning have been raised to adequate levels and above the European average. Factors also helping with the reduction of NPEs are falling unemployment, rising house prices, and solid economic growth. Partly driven by the strengthening of the Cypriot economy, the housing market has continued to recover, with prices growing by 2.7% year-on-year in Q1 2019, according to the Central Bank of Cyprus index.

Political Stability Supports the Government’s Capacity to Addressing Economic Challenges

Cyprus benefits from a stable political environment and sound institutions. The government also remains committed to addressing the country’s challenges. The government lacks a majority in the House of Representatives (HoR), and this has resulted in delays in adopting pending reforms, including those of the public administration and the local governments. The government, nevertheless, managed to get approval of the legislation related to its strategy for the reduction of the NPEs in July 2018. The reform of the judicial system to improve its efficiency, and which should enhance the efforts for the NPEs reduction, is ongoing. However, the HoR presented an amendment to the foreclosure law in August 2019, raising concerns about backtracking on the enhancement of the legal framework adopted last year. This latest amendment has not been adopted and has been submitted to the Supreme Court.

External Imbalances Persist But Are Contained

Given its small economy, Cyprus’s current account is influenced by large exports and imports of transport equipment related to investment, mainly ships. Cyprus’s current account improved in 2018, recording a deficit of 4.4% of GDP compared to a deficit of 5.1% in 2017, mainly driven by higher growth in exports of goods. Cyprus’s negative net international investment position (NIIP) remained large at 121.3% of GDP in 2018 but it continues to improve. The current account deficit and the NIIP reflect in large part activities in the international business centre and special purpose entities (SPEs) operating in the shipping sector, with limited production in the domestic economy. This supports DBRS Morningstar’s assessment for the Balance of Payments building block. Adjusted for the impact of SPEs transactions, the current account deficit was 3.4% of GDP and the negative NIIP was 39.5% in 2018.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments.
http://www.dbrs.com/research/352829

EURO AREA RISK CATEGORY: LOW

Notes:

All figures are in euro (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Fiscal balances include one-offs. Excluding one-off support measures related to Cyprus Cooperative Bank, the fiscal surplus is estimated at 2.9% of GDP in 2018.

The principal applicable methodology is the Global Methodology for Rating Sovereign Governments, which can be found on the DBRS Morningstar 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 Cyprus Ministry of Finance, Public Debt Management Office, Central Bank of Cyprus, Statistical Service of the Republic of Cyprus, Bank of Cyprus, Hellenic Bank, European Commission, European Central Bank (ECB), Eurostat, OECD, IMF, World Bank, UNDP, BIS, Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

DBRS Morningstar 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 Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar 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: July 12, 2013
Last Rating Date: May 17, 2019

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