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

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 considerable deterioration in economic performance and public finances caused by the global Coronavirus Disease (COVID-19). Following a period of robust economic growth, Cypriot GDP contracted sharply by 5.1% in 2020, although less severely than the euro area. The fiscal surplus turned to a deficit of 5.8% of GDP in 2020 and the public debt-to-GDP ratio rose to a still manageable 119.1% in 2020. The still challenging pandemic situation in the first months of this year, requiring tighter restrictions and additional support measures, led to adverse revisions to growth and fiscal deficit forecasts in 2021. Nevertheless, DBRS Morningstar expects the Cypriot economy eventually 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, remains uncertain and dependent on successfully controlling the virus.

Notwithstanding the turbulence caused by the pandemic, Cypriot banks managed to substantially reduce their stock of non-performing exposures (NPEs) from EUR 9.1 billion in 2019 to EUR 5.1 billion in 2020, mostly through sales and write-offs. Legacy NPEs remain sizable and new problematic assets could surface as public support is withdrawn, especially as an extensive loan repayment moratoria ended in December 2020. Early indications suggest limited impact thus far.

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 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 reducing banks’ legacy NPEs and the strengthening of the banking sector would be positive for the ratings. 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.

RATING RATIONALE

The Impact on the Cypriot Economy from the COVID-19 Pandemic Has Been Comparatively Less Severe

The pandemic shock halted a period of strong economic performance in Cyprus, with annual GDP growth averaging 4.6% during 2015-2019. The restrictions on mobility, travel bans, and social distancing introduced to contain the spread of the virus severely disrupted economic activity in 2020, especially impacting the tourism related activities. Including indirect and induced effects, the travel and tourism industry contributes 13.8% to overall GDP, according to the World Travel & Tourism Council. Despite its high reliance on the tourism sector, the contraction in Cypriot GDP at 5.1% in 2020 was less pronounced when compared to the euro area and to the expectations at the onset of the pandemic. The sizable and timely measures adopted by the authorities, coupled with a milder first wave of the pandemic in Cyprus, have softened the blow to domestic demand, with most of the contraction explained by the collapse in net exports.

The latest projections from the government point to a gradual recovery, with GDP growth of 3.6% in 2021, 3.8% in 2022, 3.2% in 2023, and 2.8% in 2024 on the back of both domestic and external demand. These projections assume that foreign tourism could reach pre-crisis levels around 2024 and a partial impact from the EU’s Recovery and Resilience Facility (RRF). The projections factor-in only 2.8% of GDP in capital expenditures linked to the EU’s RRF during 2022-2026 compared to the allocated grants estimated at around 5.0% of 2020 GDP. Also, the government estimates that the termination of Cyprus’s citizenship by investment programme since October 2020 could impact GDP negatively by 0.4 percentage points annually during 2021-2023, mainly affecting real estate and construction prospects.

DBRS Morningstar considers that the support measures to protect employment and productive capacity have been effective thus far in limiting any potential impact on future growth rates. Nevertheless, the pace of the recovery remains uncertain and will depend principally on the epidemiological situation both in Cyprus and in its main tourist markets. As Cyprus exits its latest short-lived lockdown in 2021, the recent pick-up in vaccination bodes well for controlling the pandemic. The progress on the vaccination front in the UK, Israel, the EU, and Russia, though with varying coverage, could allow for a gradual return of foreign tourists starting this summer season. 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. Also, a higher than expected implementation of the EU’s RRF funds constitutes an upside risk. 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

The marked improvement in Cyprus’s underlying fiscal position between 2014-2019 combined with a forceful response from the European institutions have provided sufficient fiscal headroom to respond to the pandemic shock. The fiscal impact of measures in response to COVID-19 on the accounts of the general government is estimated at -3.6% of GDP in 2020 and around -3.4% in 2021. In addition to the extra healthcare-related spending, the main measures include a short-term working scheme to support households’ income, subsidies to small enterprises and the self-employed, tax relief for businesses and households, and postponement of social contributions. As the bulk of the measures expire in 2021, with the exception of the interest subsidy schemes and the tax credit for voluntary rent reduction, the fiscal cost is expected to drop sharply for 2022-2024. Similar to other countries, Cyprus has also introduced several measures to support the economy without an immediate impact on fiscal accounts, including tax deferrals and a loan repayment moratoria. A public guarantee scheme for EUR 1 billion to support corporate lending through a 70%-30% risk sharing between state and banks could be introduced, subject to European Commission’s approval.

The fiscal support measures together with lower revenues reflecting the economic recession shifted the fiscal surplus of 1.5% of GDP in 2019 into a deficit of 5.8% in 2020. The large primary surplus of 3.8% in 2019, which was among the largest in the euro area, turned into a 3.6% deficit in 2020. In its latest Stability Programme, the government now forecasts a deficit of 4.7% of GDP in 2021, compared with the 0.7% included in the 2021 draft budget. The deterioration in the projections mainly reflects the extension of support measures and a weaker rebound in activity as a result of the still challenging epidemiological situation. Going forward, the deficit is projected to decrease considerably to 0.9% of GDP in 2022 and to return to a surplus of 0.1% in 2023 and to 1.6% in 2024. In addition to the uncertainty associated to the pandemic, changes to international corporate taxation could undermine revenue collection in coming years, given Cyprus’s relatively high share of fiscal revenues coming from this source.

The higher financing needs and the economic contraction triggered by the pandemic, coupled with a substantial increase in Cyprus’s cash buffer, resulted in a sharp increase in the public debt ratio from 94.0% of GDP in 2019 to 119.1% in 2020. Indeed, taking advantage of the high liquidity available, the government as a precaution enlarged the cash buffer from the 2.4%-5.3% of GDP observed during 2015-2019 to 17.3% of GDP in 2020. DBRS Morningstar introduced a positive qualitative assessment for the “Debt and Liquidity” building block to account for this. Going forward, provided that the healthcare situation normalises, the government projects the public debt ratio to return to its pre-crisis downward trend. The economic recovery, utilisation of the cash buffer to repay debt coming due, and primary balance turning positive are expected to underpin this trend. Noteworthy, pre-pandemic, Cyprus’ robust growth, large primary surplus, and early debt repayments allowed the government to reduce the debt ratio between 2014-2019, excluding the one-off jump related to the sale of Cyprus Cooperative Bank (CCB) in 2018.

While the government debt ratio remains very high, 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 sale 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. Government debt maturities have been extended, with the average maturity of marketable debt reaching 7.9 years in 2020. The medium-term public debt management strategy provides for a liquidity buffer to cover at least 9-month funding needs, which Cyprus currently exceeds comfortably. Moreover, the weighted average cost of debt has declined, from a peak of 4.2% in 2012 to 1.7% in March 2021.

Risks to Financial Stability Have Declined in Recent Years But Remain Relatively High

The main challenges to financial stability are linked to the still high level of legacy NPEs and to the risk of COVID-19 induced deterioration going forward. This weighs on DBRS Morningstar’s qualitative 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 January 2021 the stock of NPEs decreased by 82%. Despite the pandemic, Cypriot banks reduced considerably their stock of NPEs over 2020, primarily through non-organic sales and write-offs, leaving the total NPE ratio at a still high 17.7% in January 2021 albeit down from 28.0% in December 2019 and 49.0% in May 2016. Outside of the banking system, the state’s asset management company (‘KEDIPES’), created to manage and dispose over time the problematic assets from the resolution of CCB in 2018, had non-performing loans (NPLs) for a gross value of EUR 6.1 billion as December 2020. The government is currently considering extending the role of KEPIDES to allow for the acquisition of NPLs collateralised by primary residences or primary business residencies.

The take-up of the government social scheme (‘ESTIA’), aimed at tackling NPEs related to retail mortgages, has been below expectations so far. About EUR 0.2 billion of NPLs were approved to enter the scheme by Q1-2021. On the other hand, the reluctance of certain debtors to enter the ESTIA scheme could help banks identify strategic defaulters and the government is working on options to resolve unviable loans. The potential impact on the debt workouts from the amendments to the foreclosure framework that entered into force in June 2020 could become clear in coming months. Banks and credit acquiring companies have voluntarily halted foreclosure procedures from mid-March 2020 to August 2020. Additionally a law was enacted for the freezing of foreclosure from December 2020 until July 2021, only to certain types of debtors. On the other hand, the government has submitted legislation to Parliament to enhance Cyprus’s secondary market for NPLs.

The weaker macroeconomic environment triggered by COVID-19 could lead to a surge in problematic assets over time as the support measures are withdrawn. The Cypriot banking system exhibits significantly higher exposure to the most affected to the pandemic when compared to the EU average. The end of the first payment moratorium in response to the pandemic, which took place from March to December 2020, could lead to new NPEs in 2021, especially for the hardest hit sectors such as the hospitality, entertainment and transport. The use of this scheme was extensive, with about half of the performing portfolio entering into moratorium (around EUR 11 billion), split roughly equally between corporate and household loans. Nevertheless, asset quality has been relatively stable in the first months of 2021 and the usage of a second moratoria scheme has been small.

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. After a sharp fall in the aftermath of the first pandemic outbreak, new lending picked up strongly in the second half of 2020 benefiting from the interest subsidy scheme for new business and housing loans. The introduction of the public guarantee scheme for EUR 1 billion could support new corporate.

External Accounts Deteriorated as COVID-19 Hit International Tourism

The current account balance deteriorated in 2020, reaching -11.9% of GDP, mainly due to the fallout of international tourism. International arrivals dropped sharply in 2020 by 84% and revenues from tourism by 85% resulting in a 34% decline in the services balance compared to the previous year. From a stock perspective, Cyprus’s negative net international investment position (NIIP), albeit significantly improving by around 32 percentage points since 2015, worsened in 2020 reaching 141.3% of GDP, reflecting partly the impact from the GDP decline. The current account deficit is expected to remain large but to improve slightly this year, as the resumption of international travel will help recover some of the losses of the travel services balance in 2020.

Despite the notable deterioration in the external accounts, DBRS Morningstar views that the impact of the activities of the special purpose entities (SPEs) to the current account and NIIP warrants a positive qualitative assessment for the “Balance of Payments” building block. The current account and the NIIP are influenced by the activities of the SPEs, especially in the shipping sector, but have limited or no presence on the domestic economy. Adjusted for the impact of SPEs transactions, the negative NIIP was around 52% in 2020.

Continuity in Macroeconomic Policies is Expected after Upcoming Legislative Election

The DISY (liberal-conservative party) led government has shown strong commitment to promoting sound fiscal policies and to addressing the country’s economic challenges. However, the government’s lack of majority in the House of Representatives (HoR) has resulted in delays in adopting pending reforms. A successful implementation of Cyprus’s recovery plan could revitalise efforts to enhance the efficiency of the judicial system, public administration, and the economy’s green and digital transition. The approval of structural reforms will most likely need cross-party support. Political pressure to the government mounted recently over Cyprus’s citizenship by investment scheme and resulted in delays in the adoption of the 2021 Budget. Nevertheless, Cyprus benefits from a stable political environment and sound institutions, which is also reflected in its strong performance in the World Bank Governance Indicators. DBRS Morningstar expects policy continuity after the next legislative elections which are scheduled on May 30th. Reunification talks, supported by the United Nations (UN), resumed again in April 2021, however, DBRS Morningstar currently assumes that the chances of a significant breakthrough remain limited.

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 USD 27,051 in 2020. 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 can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/378532.

EURO AREA RISK CATEGORY: LOW

Notes:
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.

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). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings, https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3, 2021).

The sources of information used for this rating include Cyprus Ministry of Finance (Cyprus Draft Budgetary Plan 2021 and Stability Programme 2021-2024), Public Debt Management Office (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 (Post-Programme Surveillance Report Autumn 2020, 2020 European Semester: Country Report), European Central Bank (ECB), Eurostat, World Economic Forum, Social Progress Imperative, 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 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. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/378533.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.

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: November 13, 2020

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