DBRS Ratings GmbH (DBRS Morningstar) confirmed the Republic of Cyprus’s Long-Term Foreign and Local Currency – Issuer Ratings at BBB (low). At the same time, DBRS Morningstar confirmed the Republic of Cyprus’s Short-Term Foreign and Local Currency – Issuer Ratings at R-2 (middle). The trend on all ratings is Stable.
KEY RATING CONSIDERATIONS
The Stable trend reflects DBRS Morningstar’s view that risks to the ratings are broadly balanced despite the economic contraction in Cyprus in 2020, brought about by the global Coronavirus Disease (COVID-19), and the deterioration in the government’s balance sheet. The Cypriot economy contracted by a less-than-expected 5.5% year-on-year in the first half of 2020, less severely than the euro area average. The fiscal surplus is expected to shift to a deficit, with the government debt-to-GDP ratio rising close to a still manageable 115% of GDP in 2020.
DBRS Morningstar expects the Cypriot economy to recover from the COVID-19 shock and the increase in the public debt ratio to reverse, although the pace of the economic recovery, particularly that of the tourism sector, is highly uncertain at the moment given the ongoing pandemic. There is also uncertainty over the impact from the loan repayment moratoria on Cypriot banks from next year. On the other hand, banks remain well capitalised and have continued to reduce their legacy non-performing loans in 2020.
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 still sizable legacy 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.
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’ legacy NPEs and the strengthening of the banking sector would be positive for the ratings. However, the ratings could be downgraded as a result of a prolonged period of significantly weak growth, combined with large fiscal imbalances or materialisation of large contingent liabilities. A material reversal of the downward trajectory in NPEs could also be negative.
The Impact on The Cypriot Economy from The COVID-19 Pandemic Has Been Comparatively Less Severe
Cyprus’s robust economic performance has been interrupted by the shock from coronavirus. Virus-containment measures and travel restrictions in Cyprus and abroad have had an impact on economic activity. Nevertheless, Cyprus started this crisis from a position of strength, growing robustly over the past five years with annual real GDP growth averaging 4.6%. Compared to other countries, the number of infections and the mortality rate have also been limited so far, and the fiscal response has been supportive. Despite a relatively high reliance on tourism, the economy has contracted by less than expected in the first half of this year. The direct contribution of the tourism sector is about 6% of GVA. Including indirect and induced effects, the travel and tourism industry contributes 13.8% to overall GDP, according to the World Travel & Tourism Council. The government has revised its 2020 GDP growth forecast to -5.5% from -7.0% initially. The contraction is projected to be followed by growth of 4.5% in 2021 as consumption recovers. For an historical comparison, the Cypriot economy contracted by a cumulative 11.8% during the 2012-2014 financial crisis.
In DBRS Morningstar’s view, the near-term growth outlook is subject to a high degree of uncertainty. It depends on the evolution of the virus, not just in Cyprus and but also in its main tourist markets, including the UK, Russia, the European Union (EU) and Israel. Europe is going through a second wave of infections and cases have also risen more rapidly in Cyprus since October. In addition to being a tourist destination, Cyprus is an attractive business services centre and shipping centre, whose performance is subject to the recovery of external demand. The suspension of the Citizenship by Investment Programme could also weigh on growth next year. Moreover, the economic outlook depends on the effectiveness of the policy response. The recovery over the few years is likely to benefit from the EU Recovery Fund. In the longer term, the expected exploitation of off-shore gas reserves represents a potential source of growth.
Cyprus Has Used Its Fiscal Space To Respond to the Crisis But Public Debt Has Risen
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 4.0% of GDP. The measures include a short-term working scheme to support households’ income, especially in the tourism sector, tax relief for businesses and households, and postponement of social contributions. The government did not adopt a loan guarantee scheme similar to other European countries, but it has adopted an interest subsidy scheme for new business loans and housing loans for 2021-2024. The government also introduced loan repayment moratorium until the end of 2020.
Cyprus had some fiscal space to respond to the crisis. The fiscal support package together with lower revenues reflecting the economic recession are set to shift the fiscal surplus of 1.7% of GDP in 2019 into a deficit of 4.5% in 2020. The large primary surplus of 4.2% in 2019, among the largest in the Euro area, is projected to turn into a 2.2% deficit in 2020. With the fiscal package being largely temporary, the government expects to reduce the headline deficit to a modest 0.7% in 2021, as presented in the 2021 draft budget.
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, 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 outstanding amount of the IMF loan of EUR 717 million in advance in February 2020. Nevertheless, the government is forecasting the debt ratio at 114.8% in 2020, before falling to 111.0% in 2021, when the primary balance is expected to turn positive again, and below 100% by 2023.
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 Cyprus Cooperative Bank sale transaction in 2018, 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. Government debt maturities have been extended, with the average maturity of marketable debt reaching to 7.8 years in September 2020. The medium-term public debt management strategy provides for a liquidity buffer to cover at least 9-month funding needs, which currently it covers a period of 12 months ahead. Moreover, the weighted average cost of debt has declined, from a peak of 4.2% in 2012 to 1.9% in September 2020.
Risks to Financial Stability Have Declined in Recent Years But Remain Relatively High
The main risk to financial stability is related to the still high level of legacy NPEs. 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 in recent years, largely driven by the government’s efforts and the banks’ sale of NPEs. From its 2015 peak to June 2020 the stock of NPEs decreased by 77%. The resolution of state-owned Cyprus Cooperative Bank in 2018 removed a third of NPEs from the banking system, which were placed in the state’s Asset Management Company and expected to be disposed of over time. The reduction in NPEs in 2019 was limited and organic through cash repayments, debt-for-assets swaps, and write-offs. In 2020, another significant reduction in NPEs has come from additional sales of banks’ NPE portfolios.
The government is implementing its social scheme (‘ESTIA’), a main pillar of its strategy to reduce NPEs related to retail mortgages, which account for a half of total NPEs. The scheme has been designed to help eligible households repay their loans, but it seems unlikely to lead a material reduction of NPEs in the Cypriot economy, as the level of participation has been low. Despite the ongoing efforts, the total NPE ratio remains high at 22.3% in June 2020, albeit down from a 49.0% peak in May 2016. In part, the still high ratio reflects the reduction in bank loans as households and businesses deleverage, with the total stock of loans in June 2020 at around half the size compared with February 2015. By segment, the household NPE ratio remains the highest at 27.9%, followed by the SME NPE ratio at 25.1%.
Cypriot banks’ operating environment has deteriorated with the current crisis. After voluntarily halting existing foreclosure procedures from mid-March to August 2020, banks and credit acquiring companies have resumed foreclosures. However, potential risks to the banking sector could emerge from the extensive use of loan repayment moratoria, adopted in response to the COVID-19 crisis. Official data show that 41% of banks’ total loans are under moratoria, with tourism, construction, and entertainment having the largest proportions. While the moratoria is not expected to result in NPEs this year, the weak environment is likely to lead to new NPEs in 2021, although the magnitude is uncertain. Moreover, the recovery of the housing market might reverse, and the recent suspension of the Cyprus Citizenship by Investment programme has added uncertainty to the prospects for the housing market in some coastal areas.
On the other hand, banks’ liquidity positions are high and capital levels and loss loan provisioning have been raised to adequate levels. The ECB Supervisory Board provided temporary capital relief measures for euro area 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 EUR 1.3 billion (almost 6% of GDP). The Central Bank of Cyprus also took measures for less significant banks, which released an additional up to EUR 0.1 billion. While bank lending has been weak this year, the interest subsidy scheme for new business and housing loans is expected to support lending in the coming years.
Political Stability Supports the Government’s Capacity to Address Economic Challenges
Cyprus benefits from a stable political environment and sound institutions. The government also remains committed to addressing the country’s economic 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 for 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 efforts for NPEs reduction, is ongoing. However, the HoR amended the foreclosure law in August 2019, which raised concerns about a backtracking on the enhancement of the legal framework adopted the year before and could potentially lead to some delays in the foreclosure timeline. This latest amendment was submitted to the Supreme Court which ruled it constitutional in June 2020.
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. The current account deficit deteriorated to 6.3% of GDP in 2019 from 3.9% in 2018, mainly driven by a deterioration in the services balance. Cyprus’s negative net international investment position (NIIP) continued to improve but remained large at 122.3% of GDP in 2019. In 2020, the current account deficit is expected to deteriorate, as the large surplus in the services balance will be affected by lower services exports and tourism revenues. In January-September 2020, tourist arrivals fell by 84.3% compared with the same period last year.
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 no or limited presence on 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 around 40% in 2019.
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 USD27.7k in 2019. This factor was taken into account within the ‘Economic Structure and Performance’ building block. However, DBRS Morningstar notes the upward trajectory in Cyprus’s per capita GDP in recent years.
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/369992.
EURO AREA RISK CATEGORY: LOW
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 https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments (July 27, 2020).
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 (Cyprus Draft Budgetary Plan 2021 and Stability Programme 2020-2023), Public Debt Management Office (Annual Funding Plan 2020 and Medium Term Public Debt Management Strategy 2021-2023), Central Bank of Cyprus, Statistical Service of the Republic of Cyprus, World Travel & Tourism Council, European Commission (2020 Autumn Forecasts), European Central Bank (ECB), Eurostat, OECD, IMF (World Economic Outlook October 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:
The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/369991.
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: Nichola James, Managing Director, Global Financial Institutions and Sovereign Ratings
Initial Rating Date: July 12, 2013
Last Rating Date: May 15, 2020
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