DBRS Ratings GmbH (DBRS Morningstar) upgraded the Republic of Cyprus’s Long-Term Foreign and Local Currency – Issuer Ratings from BBB (low) to BBB and changed the trend from Positive to Stable. At the same time, DBRS Morningstar upgraded the Republic of Cyprus’s Short-Term Foreign and Local Currency – Issuer Ratings from R-2 (middle) to R-2 (high) and changed the trend from Positive to Stable.
KEY RATING CONSIDERATIONS
The ratings upgrades reflect Cyprus’s stronger-than-anticipated economic and public finance performance during 2021 and DBRS Morningstar’s expectation that medium term conditions remain supportive of Cyprus’s debt reduction efforts, despite risks posed by Russia’s invasion of Ukraine and the pandemic. The Cypriot economy exceeded its pre-pandemic real GDP level during 2021, in spite of the only partial recovery of the tourism sector. The fiscal repair has progressed much faster than anticipated in 2021, with the fiscal deficit falling to 1.8% of GDP from 5.6% of GDP in 2020, mainly driven by strong revenue growth. DBRS Morningstar notes that Cyprus returned to a small primary surplus of 0.1% of GDP in 2021. In this context, Cyprus’s elevated public debt ratio decreased from 115.0% of GDP in 2020 to 103.9% of GDP in 2021. Furthermore, the banking system’s continued non-performing exposures (NPEs) reduction and limited impact from the pandemic on asset quality are supportive factors for the upgrade. Improvements in DBRS Morningstar’s building blocks of “Fiscal Management and Policy”, “Debt and Liquidity” and “Monetary Policy and Financial Stability” are the key factors for the upgrades.
The Stable trends reflect DBRS Morningstar’s view that the risks remain broadly balanced. Cyprus is one of the European Union (EU) countries most heavily exposed to the Russian market and therefore uncertainty over the duration of the invasion and its impact on longer term fiscal and debt metrics raises uncertainty. However, DBRS Morningstar considers that the impact on credit metrics will most likely be contained.
DBRS Morningstar expects some direct and indirect negative impacts on Cyprus’s economy from Russia’s invasion of Ukraine on economic growth in 2022, given a high exposure to Russia, especially in the tourism and professional services sectors where recovery will be slower than expected. Also, increasing energy prices will exacerbate the already elevated inflationary pressures and further erode household’s purchasing power. Nevertheless, DBRS Morningstar takes the view that Cyprus's medium-term economic prospects remain solid and the country should be well placed to manage and adjust to the shock. The recovery of foreign tourism and private consumption, albeit at a slower pace, and the positive impact on investment and reforms from EU funds should support economic growth. The main downside risk stems from the duration of Russia’s military operations in Ukraine, harsher sanctions or counter sanctions, and broader spillovers to the domestic economy. On the other hand, if effectively implemented, the investments and reforms linked to the EU funds could durably raise Cyprus’s medium to longer-term growth prospects.
DBRS Morningstar considers that the growth slowdown in 2022 and potential new supportive policy measures could delay but not derail the return to fiscal surpluses in coming years. DBRS Morningstar continues to expect the public debt ratio to continue declining over the medium term driven by Cyprus’s solid growth prospects, a return to recurring surpluses, and gradual unwinding of its extraordinarily high cash buffer. On the other hand, the pandemic’s adverse effect on tourism continues to weigh on the external accounts. A reduction in Russian visitors as well as an even higher energy import bill could compound the deterioration this year.
The BBB 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. On the other hand, Cyprus also faces significant credit challenges due to its high levels of private and public sector debt, external imbalances, and the small size of its service sector-driven economy, which exposes Cyprus to adverse changes in external demand. The still sizable legacy NPEs in the banking sector and the economy remain a challenge, although has been improving markedly in recent years.
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 leading to a faster than expected reduction in the public debt ratio in coming years; (2) evidence of increased economic resiliency and flexibility.
The ratings could be downgraded if one or a combination of the following occur: (1) a significant deterioration in the public debt trajectory, potentially due to a prolonged period of weak growth, large fiscal imbalances, or materialisation of large contingent liabilities; (2) a material reversal of the downward trajectory in NPEs.
The Economy Has Recovered Faster Than Expected From The Pandemic But Economic Linkages with Russia Increase Risks
The pandemic halted a period of strong economic performance in Cyprus, with annual real GDP growth averaging 5.3% in the 2015-19 period. Despite its small economic size and the importance of the tourism sector, the Cypriot economy has recovered relatively quickly from the pandemic shock. After a contraction of 5.0% in 2020, real GDP grew 5.5% in 2021 driven by domestic demand and exceed its pre-crisis levels in Q3-2021. From a sectoral perspective, the information and communications and financial sectors outperformed the sectoral average since the pandemic hit, while the tourism industry is still in a recovery phase. DBRS Morningstar considers that Cyprus's improving economic fundamentals prior to the pandemic, combined with strong public support measures, were crucial to weather the challenges of the pandemic. The policy support has been effective in limiting the risk of long-term scarring, with the employment rate at 60.5% and unemployment rate at 6.3% in Q4 2021, close to pre-pandemic levels.
DBRS Morningstar expects Russia’s invasion of Ukraine to force a significant deceleration in Cyprus’s economic growth in 2022, given its high exposure to Russia, especially in the tourism and professional services sectors (please see Cyprus: Important Economic Links With Russia Increase Risk: https://www.dbrsmorningstar.com/research/393664). The IMF in its latest assessment has reduced its growth forecast for Cyprus to around 2.0% in 2022. DBRS Morningstar expects GDP growth to regain strength as it redirects trade away from Russia towards other markets. Private consumption and net exports should benefit from the reopening of the economy and the full return of foreign tourism over time. Investments will be supported by EU funds.
The main downside risk stems from deeper, more protracted, and more extensive spillovers to the domestic economy from Russia’s invasion. Also, the pandemic remains a source of uncertainty. On the other hand, an effective implementation of investments and reforms in Cyprus’s recovery plan could lead to GDP outcomes more favourable than currently envisaged. For example, 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, including the EUR 157 million in pre-financing received in 2021, as well as from the Multiannual Financial Framework (EUR 1.0 billion) during 2021-2027. In the longer term, the expected exploitation of off-shore gas reserves represents a potential source of growth.
The Fiscal Deficit Declined Markedly But Uncertainty Remains High
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 and the collapse of revenues due to the pandemic-induced recession led to a substantial deterioration in public finances, with the fiscal deficit reaching 5.6% of GDP in 2020 after a surplus of 1.3% in 2019. The Ministry of Finance estimates the total costs of the COVID-19 measures stood at 3.6% of GDP in 2020 and 3.1% of GDP in 2021. Despite the extension of fiscal policy support during 2021, the preliminary results suggest a significant reduction in the fiscal deficit to 1.8% of GDP in 2021, well below the 5.0% of GDP previously anticipated. DBRS Morningstar notes that Cyprus returned to a small primary surplus of 0.1% of GDP in 2021. The fiscal overperformance is largely explained by the sharp increase of 16% YoY in total revenues, benefitting from stronger-than-expected economic and labour market conditions, that more than compensated for the higher spending of 5.8% YoY in 2021.
As outlined in its October 2021 fiscal targets, Cyprus aims for a fiscal deficit of 1.1% of GDP in 2022 and 0.5% in 2023, and a return to surplus of 0.8% of GDP in 2024. The sizable fiscal outperformance in 2021, combined with the end of most of the COVID-19 support measures in 2021, bode well for the achievement of these targets. Cyprus’s track-record before the pandemic gives credibility to the path. On the other hand, a negative economic shock, including a deeper and more protracted impact from the situation in Ukraine or restoration of pandemic restrictions, are the main challenge to this rebalancing process, in DBRS Morningstar view. The government could introduce additional measures to compensate for the surge in energy prices weighing on households and firms. Other sources of risk to the fiscal trajectory include: 1) containing expenditures, especially in health and wages, amid high inflation, 2) higher-than-anticipated costs to fund the transition to Cyprus’s National Health System, requiring additional transfers from the state, 3) fiscal impact of the plan to broaden KEDIPES scope, and 4) changes to international corporate taxation regimes that could undermine revenue collection in coming years, given Cyprus’s relatively high share of fiscal revenues coming from this source. Therefore, DBRS Morningstar will continue to focus on the ability of the government to deliver on its medium term fiscal targets, harnessing its fiscal sustainability and driving the reduction of the public debt ratio.
The Public Debt Ratio Resumed A Downward Path But Uncertainty Lingers
DBRS Morningstar views Cyprus’s elevated public debt levels as an important constrain to the rating. The public debt ratio declined by about eleven percentage points to 103.9% of GDP in 2021 from the 115.0% reached in 2020, reversing close to half of the increase triggered by the pandemic in 2020. DBRS Morningstar notes that thirteen of the twenty four percentage-point increase in the public debt ratio in 2020, from 91.1% to 115.0% of GDP, could be explained by the increase in the cash buffer. The cash buffer stood at 16.7% of GDP in 2020, compared to 4.1% in 2019, and remained high at 11.8% of GDP in 2021. DBRS Morningstar maintained a positive qualitative adjustment for the Debt and Liquidity building block assessment to account for this buffer.
DBRS Morningstar expects Cyprus to continue reducing its public debt ratio materially over the medium-term. The government projected a decline to 100.9% of GDP in 2022, 96.9% in 2023, and 90.2% of GDP in 2024. While the potential economic and financial fallout from Russia’s invasion of Ukraine has increased uncertainty over the improving debt path, DBRS Morningstar takes the view that near term delays may occur but that the underlying medium-term trends driving the debt ratio downward remain in place. Cyprus’s strong medium-term growth outlook, a return to recurring solid primary surpluses, and a gradual drawdown of the extraordinarily high cash buffer are expected to drive the reduction in public indebtedness in coming years. The main risks to this trend stem from a negative economic shock, materialisation of contingent liabilities related to the still high level of non-performing exposures in the banking system, and a substantial increase in funding costs not accompanied by an improving domestic economy.
Despite these underlying risks, DBRS Morningstar notes several mitigating factors. Medium-term public debt management strategy plans for a liquidity buffer to cover funding needs of at least nine months, which the current buffer provides comfortably. Also, Cyprus has taken the opportunity presented by the extraordinarily favourable monetary policy conditions and better fundamentals to improve its debt profile and to reduce its refinancing risks. Cyprus managed to materially lengthen its average maturity profile and reduce its funding costs over the last decade, including early repayment of loans to Russia and the IMF in recent years. The weighted-average cost of debt declined to 1.6% in 2021 from a peak of 4.2% in 2012, while the weighted-average maturity of debt increased from 4.5 years to 7.6 years in 2021. Provided that bond yields increase over time gradually, the fact that more expensive debt will come due implies that Cyprus’s weighted average cost of financing should decline further in the next few years. Furthermore, nominal growth is expected to continue to outpace interest costs, creating a reverse snow-ball effect.
Risks to Financial Stability Have Declined in Recent Years But Remain Relatively High
The high level of legacy non-performing assets in the banking system, with Cyprus having the second highest NPE ratio in the EU after Greece, and elevated overall indebtedness remain sources of vulnerability. Also, Cypriot banks’ comparatively weak profitability is another important challenge. However, DBRS Morningstar views positively the significant progress in cleaning-up the banking system, including an acceleration during the pandemic. Cypriot banks managed to reduce the aggregate NPEs ratio (excluding exposures towards central banks and credit institutions) substantially from 27.9% in February 2020 to 11.1% in December 2021, mainly as a result of sales and write-offs. The clean-up is more remarkable when compared with the NPE ratio peak of 49.0% in May 2016. 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 last year benefiting from the interest subsidy scheme for new business and housing loans.
The impact of COVID-19 on asset quality has remained limited thanks to the direct fiscal measures and the implementation of the first moratoria scheme. The performance of the loans exiting this scheme has been encouraging with only 4.6% of exposures presenting arrears and over 90% of loans already restarting their repayment schedule by end-2021. However, DBRS Morningstar continues to monitor asset quality as COVID-19 measures end and sectors still recovering from the pandemic are now adversely affected by sanctions on Russia. These risks are visible in the 34% increase in Stage 2 loans since the pandemic started and the sizable exposure to the sectors hardest hit by the pandemic, with exposures to the accommodation, transport, and entertainment sectors amounting to 26% of the non-financial corporations (NFC) loan portfolio. This leads to a negative qualitative adjustment to DBRS Morningstar’s Monetary Policy and Financial Stability building block assessment. On the other hand, banks’ strong capital levels above regulatory requirements and very high liquidity levels provide important safeguards. Positively, Cypriot banks’ capitalisation levels remained stable even after the substantial disposal of NPEs in recent years.
DBRS Morningstar considers that the direct risks to Cyprus’s banking system from Russia’s invasion of Ukraine are manageable. Cypriot banks’ combined direct exposure to Russia and Ukraine accounts for less than 1% of total assets. While the share of combined deposits from Russia and Ukraine represents close to 4.7% of total deposits, the Cypriot banking system has ample liquidity buffers to weather potential deposit outflows from these markets. The voluntary decision of RCB Bank Ltd, which represented around 8% of total assets of Cypriot banks, to phase out its banking operations in Cyprus, could reduce further the linkages of the Cypriot banking system to Russia in coming months. The sale of part of its performing loan portfolio, which was approved by the ECB, in conjunction with the bank’s high liquidity buffers and sufficient capital buffers should avoid depositors’ losses and prevent broader deposit outflows.
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. The foreclosure framework will remain to be tested as foreclosures regain pace after suspension for several months due to the pandemic.
Tourism And Terms of Trade Weigh On The External Accounts
Following a high deficit of 10.1% of GDP in 2020, Cyprus posted another sizable current account deficit of 7.3% of GDP in 2021. The partial rebound of the tourism market last year resulted in a travel balance surplus of 3.7% of GDP in 2021 from a small deficit in 2020. Foreign tourism recovered some of the 2020 loses, with international tourist arrivals in 2021 reaching around 50% of 2019 levels. The current account deficit is expected to remain large as strengthening domestic demand and increased import prices are expected to widen the trade deficit. Historically, Cyprus’s deficit in the current account is explained by the negative trade balance due to the high reliance on imports of goods and its dependence on imported energy sources and by the deficit in the income accounts.
Cyprus’s negative net international investment position (NIIP) remains high at 123.3% of GDP in 2021. However, DBRS Morningstar notes that the underlying imbalances are magnified by the impact of the activities of the shipping sector on the external accounts, as a large portion of the NIIP negative position is attributed to the special-purpose entities (SPEs) operating in the shipping sector, with limited presence in the domestic economy. Adjusted for the impact of SPE transactions, the current account deficit was 8.6% of GDP and the negative NIIP was 43.5% of GDP in 2021.
Despite a partial recovery last year, Russia’s invasion of Ukraine brings new headwinds for Cyprus’s tourism sector.
Given the importance of the Russian tourism market, the sanctions and countersanctions imposed to and from Russia, including the closure of EU airspace to Russian aircrafts and airlines dampen the outlook for the Cypriot tourism market this year. In 2021, Russia’s market represented the highest source tourism market for Cyprus, accounting for approximately 27% of total arrivals, followed by the United Kingdom market which accounted for approximately 20%. The degree to which Cyprus will mitigate the adverse effects of the potential loss of Russia’s tourism market will depend on the duration and depth of the crisis and on its ability to achieve market diversification by identifying potential new markets, while strengthening its presence in existing tourism markets.
Despite the Deterioration In Governance Indicators in 2020, Policy Making Remains Predictable
Cyprus benefits from strong institutions and a stable political environment. The May 2021 legislative elections resulted in another minority position in the House of Representatives (HoR) for the liberal-conservative party DISY. Since 2013, DISY- led consecutive governments have shown commitment to promote sound fiscal policies and to address the country’s economic challenges. Looking ahead, the government is expected to direct its attention to the implementation of Cyprus’s recovery plan, which aims to enhance the efficiency of the judicial system and the public administration, to combat corruption, and to boost the economy’s green and digital transition. The implementation of the plan will depend on the government’s ability to garner sufficient support in parliament to pass legislation. Despite the significant deterioration in the World Governance Indicators of ‘Control of Corruption’ (66.9 percentile rank) and ‘Rule of Law’ (70.7 percentile rank), which are now worse than the EU average, DBRS Morningstar views that Cyprus’s EU and eurosystem membership supports its credible policy framework. 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.
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 29,496 in 2021. 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/395022.
EURO AREA RISK CATEGORY: LOW
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, October 2021; Cyprus Recovery and Resilience Plan 2021-2026, May 2021), Public Debt Management Office, Central Bank of Cyprus, Statistical Service of the Republic of Cyprus, European Commission (Analysis of the Recovery and Resilience Plan of Cyprus, August 2021; Post-Programme Surveillance Report Autumn 2021, Nov 2021), European Central Bank (Press Release - ECB takes decisions related to RCB Bank phasing out its banking operations, March 2022), European Banking Authority, Eurostat, Social Progress Imperative (2021 Social Progress Index), OECD, IMF (Cyprus: Staff Concluding Statement of the 2022 Article IV Mission, March 2022), World Bank, 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 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/395021.
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: October 22, 2021
DBRS Ratings GmbH, Sucursal en España
Paseo de la Castellana 81
Plantas 26 & 27
28046 Madrid, Spain
Tel. +34 (91) 903 6500
DBRS Ratings GmbH
Neue Mainzer Straße 75
60311 Frankfurt am Main Deutschland
Tel. +49 (69) 8088 3500
Geschäftsführer: Detlef Scholz
Amtsgericht Frankfurt am Main, HRB 110259
For more information on this credit or on this industry, visit www.dbrsmorningstar.com.