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

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 Positive from Stable. 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 Positive from Stable.

KEY RATING CONSIDERATIONS
The Positive trend reflects DBRS Morningstar’s expectation that Cyprus’s public debt ratio will most likely return to its pre-pandemic downward path starting this year underpinned by a solid economic growth, fiscal repair, and a reduction in the cash buffer. The Coronavirus Disease (COVID-19) continues to pose challenges and brings uncertainties to the economic and fiscal outlook; however, DBRS Morningstar views favourably Cyprus’s relative economic performance and improving health situation.

Despite the importance of tourism-related activities, the Cypriot economy has proven more resilient than anticipated, setting the conditions for strong growth in the medium term. The prospects for recovery of foreign tourism to the pre-COVID-19 levels over time and European Union (EU) funds disbursement and reform effort should also support this. Noteworthy, the effective implementation of the investments and reforms under Cyprus’s National Recovery and Resilience Plan (NRRP) could lead to improved longer-term prospects for the country. Against this backdrop, the fiscal position is expected to strengthen and eventually return to healthy surpluses. In addition, the public debt ratio reduction will be supported by the stock-flow adjustment effect as an extraordinarily high cash buffer is partially unwound. DBRS Morningstar views positively the banking system’s substantial reduction of non-performing exposures (NPEs) in 2020 and the performance of the asset quality metrics thus far. However, legacy NPEs remain sizable and new problematic assets could surface as public support is withdrawn.

The BBB (low) ratings are supported by Cyprus’s prudent public debt management framework, its good track record with respect to 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 one or a combination of the following occur: (1) sustained economic growth and an improvement in the fiscal position, putting the public debt ratio on a firm downward trajectory again; (2) continued progress in reducing banks’ legacy NPEs and the strengthening of the banking sector. A return to a Stable trend could occur if economic recovery is significantly softer than expected.

The ratings could be downgraded if one or a combination of the following occur: (1) a prolonged period of significantly weak growth, combined with large fiscal imbalances or materialisation of large contingent liabilities; (2) a material reversal of the downward trajectory in NPEs.

RATING RATIONALE

The Public Debt Ratio Has Risen Sharply But Is Expected to Commence a Downward Path Benefitting From Sound Management

After the sharp increase in 2020 triggered by the pandemic, DBRS Morningstar expects the public debt ratio to return to its pre-crisis downward trend. The public debt ratio rose sharply to 119.1% in 2020 from 94.0% of GDP in 2019 driven not only by the higher financing needs and the economic contraction triggered by the pandemic, but also by the substantial increase in the state’s cash buffer. The precautionary enlargement of the cash buffer explained 13 points of the 25 percentage-point increase in the public debt ratio in 2020. DBRS Morningstar introduced a positive qualitative factor for the Debt and Liquidity building block assessment to account for this. Going forward, Cyprus’s strong economic outlook, a return to sound primary balances, and a gradual drawdown of the extraordinarily high cash buffer are expected to result in a material reduction in the public debt ratio in coming years. The government expects the debt ratio to drop by 11.4 percentage points to 107.7% of GDP in 2021 and by close to 7.0 percentage points to 100.9% of GDP in 2022, principally driven by the stock-flow adjustment effect. According to the latest International Monetary Fund (IMF) projections, the public debt ratio is expected to drop to 83.4% of GDP by 2026, staging a reduction in the ratio of close to 36 percentage points compared with its 2020 level.

The main risks to debt dynamics stem from the materialisation of contingent liabilities and a growth shock. In an adverse macroeconomic scenario, the still high level of non-performing exposures in the banking system poses a risk to public debt. The government is exposed to losses associated with the state asset protection scheme granted to Hellenic Bank, although only partially, as well as to potential financial support to the banking system under an adverse macroeconomic scenario.

Despite these underlying risks, DBRS Morningstar notes several mitigating factors. DBRS Morningstar expects Cyprus to continue to benefit from very low financing costs in coming years. The weighted-average cost of debt has declined, to 1.7% in August 2021 from a peak of 4.2% in 2012. Even as interest rates are likely to increase over time, the fact that more expensive debt will come due will mean Cyprus’s weighted average cost of financing should drop further in coming years. Cyprus’s pre-pandemic efforts to reduce the debt ratio in recent years, including early repayment of loans to Russia and the IMF, provide further reassurance in the government’s ability and willingness to continue this process. Furthermore, 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 funding needs for at least nine months, which Cyprus currently exceeds comfortably.

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

The pandemic shock halted Cyprus’s strong economic performance, with annual GDP growth averaging 4.6% in the 2015-19 period. This was underpinned by Cyprus’s successful implementation of structural reforms, progress in restructuring its banking system, and prudent fiscal policies. DBRS Morningstar views that Cyprus’s improving economic fundamentals and strengthening fiscal accounts before the pandemic, coupled with the European institutions’ strong support initiatives, allowed the authorities to implement a sizable and timely response, mitigating the impact from the COVID-19 shock. From a healthcare perspective, Cyprus’s high testing rate for COVID-19 and more recently high levels of vaccination have helped contain the spread of the pandemic to some extent.

The measures to contain the spread of the pandemic, including lockdowns and travel restrictions, have impacted heavily tourism-related activities. While Cyprus has been diversifying away from tourism since the early 2000s, the travel and tourism industry contributed 13.8% to overall GDP in 2019, according to the World Travel & Tourism Council. Despite the importance of the tourism related activities, GDP contracted 5.1% in 2020, less than originally expected and by less than the EU, as the authorities’ response cushioned the blow to domestic demand. The most important measures included wage subsidisation, rent and operational cost subsidisation for small and medium-size enterprises and self-employed individuals, tax deferrals, and an extensive loan moratorium. The labour market held up relatively well in this context. The government raised their GDP growth projection for 2021 to 5.5% from 3.6% due to the stronger-than-expected rebound of 4.8% YOY in seasonally adjusted GDP during H1, a solid vaccination rollout, and a gradual return of tourism. Cypriot GDP could recover its pre-crisis level as early as this year, given the strong performance in the information and communications and manufacturing sectors, that are already above Q4 2019 levels, and the ongoing recovery of the contact-intensive sectors.

DBRS Morningstar considers that Cyprus’s economic outlook is strong in the medium term, given the favourable conditions in place. Private consumption is expected to recover strongly as the economy reopens, net exports to benefit from the important return of foreign tourism over time, and investments from the substantial support from the EU funds. Cyprus is expected to receive a substantial amount of funds from the Next Generation EU financial instrument (EUR 1.0 billion in grants and EUR 200 million in loans) during 2021-2026 and from the main body of the Multiannual Financial Framework (EUR 1.0 billion) during 2021-2027.

Both the government and the IMF project a solid growth trajectory. The government forecasts annual average growth of 4% during 2021-2024 and the IMF of 3.3% during 2021-2026. The main downside risk to the economic outlook remains associated to the pandemic and the potential scarring effects on the tourism sector. In the near term, supply-side disruptions and high fossil fuel prices could slow down the recovery. On the other hand, an effective implementation of investments and reforms in Cyprus’s recovery plan could lead to stronger growth in the short and long run. In the longer term, the expected exploitation of off-shore gas reserves represents a potential source of growth.

Fiscal Position to Strengthen As Pandemic Wanes

The marked improvement in Cyprus’s underlying fiscal position between 2014-2019 combined with a strong policy response from the European institutions have provided sufficient fiscal headroom to respond to the pandemic shock. The support measures of one-off nature and the collapse of revenues due to the COVID-19 disease induced recession led to a substantial deterioration in public finances, with the fiscal deficit reaching 5.7% of GDP in 2020 after a surplus of 1.5% in 2019.

The fiscal deficit is expected to remain high in 2021 at around 5.0% of GDP as the government extended its fiscal support to the economy through three additional supplementary budgets, with an estimated cost of 1.2% of GDP in 2021, in the face of a still challenging pandemic situation. As the economic and health situation permits, DBRS Morningstar expects Cyprus will regear fiscal policy towards ensuring fiscal sustainability in the medium-term as seen before the pandemic. The fiscal position should improve more rapidly starting in 2022 as COVID-19 related spending wanes and the macroeconomic environment strengthens over time. The latest projections from the Ministry of Finance point to a fiscal deficit of 1.1% of GDP, a return to primary surplus of 0.7% of GDP in 2022 and a return to twin surpluses of 0.8% of GDP and 2% of GDP respectively by 2024. In addition to the uncertainty associated to the pandemic, the risk of higher-than-anticipated costs to fund the transition to Cyprus’s National Health System, requiring additional transfers from the state, could delay this envisaged improvement. Also, changes to international corporate taxation regimes could undermine revenue collection in coming years, given Cyprus’s relatively high share of fiscal revenues coming from this source.

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

The still high level of legacy non-performing assets, both inside and outside the banking system, and the highly indebted private sector remain important challenges to financial stability. DBRS Morningstar views positively the significant progress in cleaning-up the banking system in recent years. During 2020, Cypriot banks managed to substantially reduce their legacy NPEs by 10 percentage points amid an unfavourable pandemic environment. The NPE ratio in the banking system fell to 17.5% in June 2021 from 49.0% in May 2016 through a combination of government actions, including the creation of the state asset management company (KEDIPES), and the sale of problematic assets and write-offs by banks. Despite this substantial progress, the NPE ratio in the banking system remains elevated, the second-highest in the EU after Greece. Going forward, DBRS Morningstar expects the sales of bad loans to non-bank institutions to remain the main driver of NPE reduction, as seen in recent years.

The fact that a significant and increasing portion of troubled assets are held outside of the banking sector highlights the importance of improving the rules and operating environment for credit acquiring and credit servicing companies, speeding up judicial processes, and having in place an effective foreclosure framework. Cyprus’s recovery plan includes positive measures in this direction. The foreclosure framework will remain to be tested as foreclosures regain pace after suspension for several months due to the pandemic.

The impact from COVID-19 on asset quality has remained contained during 2020 and the first half of 2021 thanks to the succession of support measures, including the direct fiscal measures and one of Europe’s most extensive loan moratoriums. Around half of the performing loan portfolio entered into the first moratorium scheme (around EUR 11 billion) between March and December 2020. The performance of the loans exiting this scheme has been encouraging with only 5.5% of exposures presenting arrears as of July 2021 and over 80% of loans already restarting their repayment schedule. With respect to new lending, after a sharp fall in the aftermath of the first pandemic outbreak, flows picked up strongly in the second half of 2020 and continued this year benefiting from the interest subsidy scheme for new business and housing loans.

Despite the better than expected performance thus far, DBRS Morningstar still sees a risk that asset quality could deteriorate in coming months as extraordinary measures are pared back, especially related to the exposures to the sectors hardest hit by the pandemic. According to European Banking Authority data, loans to the hospitality, entertainment, trade, and transport sectors represented close to 50% of the non-financial company (NFC) loan portfolio of Cypriot banks, which is the highest in the EU, closely followed by Greece. A surge in credit losses could compound some of the longstanding vulnerabilities weighing on the profitability of the Cypriot banks. This forward-looking risk weighs on DBRS Morningstar’s Monetary Policy and Financial Stability building block assessment. On the other hand, banks’ strong capital levels above regulatory requirements, loss loan provisions at adequate levels, and very high liquidity levels provide important safeguards. Cypriot banks’ capitalisation and coverage ratios remain broadly at similar levels even after the substantial disposal of NPEs during 2020.

External Accounts Deteriorated as COVID-19 Hit International Tourism

The current account deficit deteriorated sharply during 2020, reaching 10.1% of GDP, due to the collapse in foreign tourism as international arrivals dropped by 84% in 2020. The travel balance shifted to a deficit of 0.1% of GDP in 2020 from a surplus of 6.3% of GDP in 2019. The current account deficit is expected to remain large but to improve marginally in 2021 helped by the resumption of international travel. Foreign tourism has recovered this summer and is expected to continue to improve; however, the government expects a full recovery only by 2023-2024. International arrivals were still below 35.3% in September and 60.1% for January-September this year, when compared to the respective same periods in 2019. Tourism during the first half of the year still suffered from a high level of restrictions to international travel.

From a stock perspective, Cyprus’s negative net international investment position (NIIP) remains elevated and worsened substantially to 136.7% of GDP in 2020 due to the large current account deficit and GDP decline. Nevertheless, DBRS Morningstar notes that the underlying imbalances are smaller than what the headline figure suggest as a large portion of the NIIP negative position is explained by special-purpose entities (SPEs) operating in the shipping sector, with limited presence in the domestic economy. Given its small economy and its role as hub for merchant shipping - the Cyprus Registry has the third-largest merchant shipping fleet in the European Union - Cyprus’s current account and net international investment position statistics are heavily influenced by the activities of the shipping sector. Adjusted for the impact of SPE transactions, the current account deficit was 9.7% of GDP and the negative NIIP was 50.3% in 2020.

Government to Continue Pursuing Fiscal Prudence and Macroeconomic Stability But Governance Perception Deteriorated in 2020

Cyprus benefits from a stable political environment and sound institutions. However, following a significant deterioration in 2020, Cyprus is underperforming the EU average in terms of ‘Rule of Law’ (70.7 percentile rank) and ‘Control of Corruption’ (66.9 percentile rank), according to the World Bank’s governance indicators. The legislative elections in May 2021 resulted in another minority position in the House of Representatives (HoR) for DISY (liberal-conservative party). The DISY-led government has shown strong commitment to promoting sound fiscal policies and to addressing the country’s economic challenges. While DISY’s lack of legislative majority could delay the adoption of reforms as seen before the elections, the EU funds could provide sufficient incentives to reach cross-party support necessary to achieve the milestones and targets of the recovery plan. A successful implementation of Cyprus’s recovery plan could revitalise efforts to enhance the efficiency of the judicial system, public administration, combat corruption, and boost the economy’s green and digital transition. With respect to the reunification talks supported by the United Nations (UN), 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 26,785 in 2020. DBRS Morningstar has taken these considerations 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 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/386453.

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in euros (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/381451/global-methodology-for-rating-sovereign-governments (July 9, 2021). 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 2022, Cyprus Recovery and Resilience Plan 2021-2026, and Stability Programme 2021-2024), Public Debt Management Office (Annual Report 2020), Central Bank of Cyprus, Statistical Service of the Republic of Cyprus, World Travel & Tourism Council, European Commission (2020 European Semester: Country Report and Analysis of the Recovery and Resilience Plan of Cyprus), European Central Bank (ECB), European Banking Authority, Eurostat, World Economic Forum, Cyprus Shipping Chamber, 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/386454.

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, Co-Head Global Sovereign Ratings
Initial Rating Date: July 12, 2013
Last Rating Date: May 14, 2021

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