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

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

KEY RATING CONSIDERATIONS

The trend change from Positive to Stable reflects the fact that the improvements in the public debt trajectory, driven by sustained robust economic growth and large primary surpluses, will no longer be the case in the near term as a result of the global Coronavirus Disease (COVID-19). To deal with the economic fallout, the government has adopted a fiscal support package that will see its fiscal surplus turn into a large deficit and its public debt to rise in 2020. DBRS Morningstar expects the Cypriot economy to eventually recover and the increase in the public debt ratio to reverse, but the timing and pace of the economic recovery are highly uncertain at the moment. The deterioration in DBRS Morningstar’s assessment of the “Fiscal Management and Policy” building block and the absence of improvement in the “Debt and Liquidity” building block were the key factors for the trend change.

The BBB (low) ratings are supported by Cyprus’s prudent public debt management framework, its good track record in fiscal deficit reduction, 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 economic growth and a sound fiscal position return, which would lead to the resumption of the downward trajectory in the public debt ratio. Moreover, further progress in substantially reducing banks’ NPEs and private sector debt, and the strengthening of the banking sector would be positive for the ratings. However, the ratings could be downgraded due to a prolonged period of significantly weak growth, combined with large fiscal imbalances or materialisation of large contingent liabilities. A sharp reversal of the downward trajectory in NPEs could also be negative.

RATING RATIONALE

The Cypriot Economy Is Being Hit by The Global Coronavirus Pandemic

Cyprus’s robust economic performance has been interrupted by the shock from coronavirus. Compared to other countries, the number of infections and the mortality rate have been limited. However, the confinement measures, including travel restrictions, imposed in mid-March to limit the spread of the virus in Cyprus and abroad are having a severe impact on economic activity, particularly on the tourism sector. The direct contribution of the tourism sector based on National Accounts data is about 6% of GVA. Including indirect, tourism accounts for about 20% of GDP, according to the European Commission. Cyprus is facing this crisis from a position of strength. Still, after growing robustly over the past five years, with annual real GDP growth averaging 4.4%, the Cypriot economy is forecast to contract sharply. The government forecasts real GDP to fall by 7.0% in 2020, followed by growth of 6.0% in 2021.

In DBRS Morningstar’s view, the near-term growth outlook is subject to a high degree of uncertainty. It depends on the effectiveness of the policy response and the easing of the lockdown measures in Cyprus and its main tourist markets, including the UK, Russia, the European Union (EU) and Israel. In addition to being a tourist destination, Cyprus is an attractive business services centre and shipping centre, whose performance is also subject to the recovery in external demand. In the longer term, the expected exploitation of off-shore gas reserves represents a potential source of growth.

The Crisis Will Result In A Fiscal Deficit And Disrupt The Downward Trajectory In The Public Debt Ratio

To support the economy during the current crisis, the government has adopted a package of measures, estimated to have a fiscal impact on the general government accounts of about 4.4% of GDP. The measures include a short-term working scheme to support households’ income, tax relief for businesses and households, postponement of social contributions, and support for the tourism sector. The government is also proposing a loan guarantee scheme and introduced loan repayment moratorium until the end of 2020, with any potential losses to be shared with the banking sector.

Cyprus had the fiscal space to respond to the crisis, but the fiscal support package and lower revenues reflecting the economic recession are set to shift the headline fiscal surplus of 2.7% of GDP in 2019 into a deficit of 4.3% in 2020, according to the government’s Stability Programme. The large primary surplus of 5.2% in 2019, among the largest in the Euro area, is projected to turn into a 1.8% deficit in 2020. With the fiscal package intended to be temporary, the government projects the headline deficit to fall to a modest 0.4% in 2021. The deterioration of the fiscal outlook has weighed on DBRS Morningstar’s qualitative assessment of the “Fiscal Management and Policy” building block.

Higher financing needs and the economic contraction will result in a sharp increase in the government debt ratio in 2020. Government debt fell to 95.5% of GDP in 2019, after an increase in 2018 associated with the sale of Cyprus Cooperative Bank (CCB). The decline was driven by robust growth, a large primary surplus and early debt repayments, including the Russian loan in September 2019. The government also fully repaid the IMF loan in advance in February 2020. However, the government is forecasting the debt ratio to increase to 116.8% in 2020, before falling again to 103.2% in 2021. The deterioration in the outlook for public debt has weighed on DBRS Morningstar’s “Debt and Liquidity” building block assessment.

While the government debt ratio is set to increase, the debt profile is expected to remain favourable. Debt dynamics are vulnerable to adverse shocks, particularly a materialisation of contingent liabilities. As part of the CCB transaction, an Asset Protection Scheme guaranteed by the state was created, increasing the government’s contingent liabilities. Nevertheless, prudent public debt management 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 8.0 years in March 2020. A liquidity buffer covers at least 9-month funding needs. Moreover, the weighted average cost of debt has declined, reaching 2.0% in March 2020 compared to a peak of 4.2% in 2012.

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. Cyprus has made significant progress in reducing vulnerabilities in the banking sector, largely reflecting the government’s stepped up efforts and the banks’ sale of NPEs. From their 2015 peak to November 2019, the stock of NPEs is down by 67%. The resolution of state-owned Cyprus Cooperative Bank effectively removed a third of NPEs from the Cypriot banking system in 2018. These NPEs are in the state’s Asset Management Company 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 2018.

The reduction in NPEs continued in 2019, but it was more limited and mainly organic, including through cash repayments, debt-for-assets swaps, and write-offs. In the year to November 2019, the stock of legacy NPEs has fallen by 8%. The total NPE ratio was still high at 28.6%, 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. By segment, the SME NPE ratio fell to 33.4% in November 2019 from 39.2% in December 2018, the large non-financial corporations NPE ratio declined to 15.4% from 19.0%, while the household NPE ratio fell only slightly to 36.3%.

Further material progress in NPE reduction in 2020 is uncertain. The government is now implementing its social scheme (‘ESTIA’), a main pillar of its NPE reduction strategy aimed at tackling NPEs related to retail mortgages, which account for a 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. Additional reduction in NPEs this year was expected to be largely driven by sales of banks’ NPE portfolios, but this is now uncertain given the current crisis. While the repayment moratoria adopted in response to the COVID-19 crisis is not expected to result in higher NPEs this year, the recession could lead to new NPEs.

Cypriot banks’ operating environment has deteriorated with the current crisis. The recovery of the housing market might also reverse. Moreover, the credit institutions and credit acquiring companies have voluntarily frozen all existing foreclosure procedures until June 2020. On the other hand, banks’ liquidity positions are high and capital levels and loss loan provisioning have been raised to adequate levels and above the European average in recent years. The ECB Supervisory Board provided temporary capital relief measures for EA banks in March 2020 to increase their capacity to lend more to the economy. In Cyprus, the capital relief for systemic banks is estimated at over EUR 1.5 billion (almost 6% of GDP). The CBC Board of Directors also took commensurate measures for less significant banks, which released an additional up to EUR 0.1 billion.

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 was 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 deficit deteriorated in 2019, to 6.7% of GDP from 4.4% in 2018, mainly driven by a deterioration in the income balance. Cyprus’s negative net international investment position (NIIP) continued to improve but remained large at 116.0% of GDP in 2019. Looking ahead, the current account deficit is expected to deteriorate, as the large surplus in the services balance will affected by much lower services exports and tourism revenues in 2020.

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 positive assessment for the “Balance of Payments” building block. Adjusted for the impact of SPEs transactions, the negative NIIP was just below 40% in 2019.

ESG CONSIDERATIONS

Human Capital and Human Rights (S) were among the key drivers behind this rating action. Compared with its euro system peers, Cyprus’s per capita GDP is relatively low at $27.7k in 2019. However, DBRS Morningstar notes the upward trajectory in Cyprus’s per capita GDP in recent years. This factor was taken into account within the ‘Economic Structure and Performance’ building block.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/361056/.

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in EUR unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments (September 17, 2019) https://www.dbrsmorningstar.com/research/350410/global-methodology-for-rating-sovereign-governments.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The sources of information used for this rating include Cyprus Ministry of Finance (Stability Programme 2020-2023), Public Debt Management Office (Funding Plan 2020), Central Bank of Cyprus, Statistical Service of the Republic of Cyprus, European Commission (2020 Spring Forecasts), European Central Bank (ECB), Eurostat, OECD, IMF (World Economic Outlook October 2019 and April 2020), 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 12-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.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/361055/.

Ratings assigned by DBRS Ratings GmbH are subject to EU and U.S. regulations only.

Lead Analyst: Javier Rouillet, 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: November 15, 2019

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