DBRS Morningstar Confirms the Republic of Cyprus at BBB, Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Republic of Cyprus’ Long-Term Foreign and Local Currency – Issuer Ratings at BBB. At the same time, DBRS Morningstar confirmed the Republic of Cyprus’ Short-Term Foreign and Local Currency – Issuer Ratings at R-2 (high). The trend on all ratings remains Stable.

KEY RATING CONSIDERATIONS
The stable outlook balances recent favourable fiscal dynamics against important downside risks for the fiscal and economic outlooks. Fiscal balances have recovered strongly over the past two years. The general government budget deficit narrowed to 1.7% of GDP in 2021 from 5.8% in 2020, driven by a strong economic growth rebound from the COVID-19 shock, which led to a marked increase in tax revenues. Budgetary outcomes have continued to improve over the past months despite the recent energy shock. During the first seven months of 2022, the general government registered a surplus of 0.6% of GDP compared to a deficit of 3.2% of GDP during the same time period in 2021 as still strong economic activity and high inflationary pressures led to a marked increase in nominal tax revenues. In addition, fiscal balances benefitted from a strong decrease in COVID-19 support measures and the so far only moderate fiscal cost of energy support measures.

Going forward, the most important downside risks are a further escalation of the conflict in Ukraine and high-for-longer energy prices, which might weaken economic activity and require a substantial increase in public support measures. Fiscal pressures might also arise from the National Health System and the planned expansion of the public asset management company KEDIPES. Public debt dynamics currently benefit from high nominal GDP growth and improved fiscal balances. The government’s stability program of April 2022 projects a decrease in the general government debt-to-GDP ratio to an albeit still high 93.9% of GDP at end-2022 from 103.9% of GDP at end-2021. Apart from a potential growth shock, risks for debt dynamics, however, might emanate from a potential materialisation of contingent liabilities related to the still high legacy stock of non-performing loans in the banking system.

The BBB ratings are supported by a stable political environment, the government’s sound fiscal and economic policies in recent years, and a favourable government debt profile. Furthermore, although governance indicators have weakened over the past years, DBRS Morningstar continues to view the country’s EU membership as an important anchor for institutional quality. On the other hand, Cyprus also faces significant challenges due to a still high public debt burden and the economy’s comparatively low level of labour productivity. Furthermore, the ratings of Cyprus continue to be constrained by the small size of its service-driven economy, which renders it vulnerable to external shocks.

RATING DRIVERS
The ratings could be upgraded if one or a combination of the following occur: (1) sustained economic growth and lasting improvements in the fiscal position leading to a marked reduction in the public debt ratio in coming years; (2) evidence of increased economic resiliency and rising labour productivity levels.

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, rising budgetary pressures, or materialisation of large contingent liabilities; (2) a material reversal of the downward trajectory in stock of NPLs in the banking sector.

RATING RATIONALE
Economic Growth Dynamics Have Remained Strong In Recent Months But Outlook Is Clouded With Uncertainty

The Cypriot economy recovered strongly from the COVID-19 shock over the past year. Real GDP expanded by 5.5% in 2021 after contracting by 5.0% in 2020 due to the reopening of the economy and still large public support measures. Growth dynamics remained strong during the first half of 2022 with (seasonally adjusted) real GDP growing by 1.3% and 0.6% on a quarter-on-quarter basis in Q1 2022 and Q2 2022, respectively. Growth was driven by rising private consumption notwithstanding a deterioration in consumer sentiment as exemplified by a marked decrease in the European Commission’s Consumer Confidence Indicator for Cyprus following Russia’s invasion of Ukraine and the accompanying increase in inflationary pressures. Annual inflation in August 2022 reached 9.6%, driven by a spike in energy prices. In addition, economic growth was supported by a strong rebound in non-Russian tourist arrivals. During the first eight months of 2022, the total number of tourists arriving in Cyprus increased by a very large 122% (y-o-y). The most visible impact of the war on the Cypriot economy has so far been a strong decrease in Russian tourist arrivals. Russian tourists accounted for 19.7% of total arrivals in 2019. The shortfall of Russian tourist arrivals is the main reason why tourism sector activity has so far not caught up to pre-pandemic levels. Despite a strong rebound, total tourist arrivals during the first eight months of 2022 were around 22% below 2019 levels.

In view of still strong growth dynamics in recent months, the Central Bank of Cyprus (CBC) in September revised its real GDP growth forecast for 2022 to 5.5%, up from 2.7% in the June forecast. At the same time, the CBC has decreased its 2023 real GDP growth forecast to 2.5% from 3.6%. The most important downside risks for the Cypriot economy are a further escalation of the military conflict in Ukraine and high-for-longer energy prices, which could raise economic uncertainty and weaken economic activity. While Cyprus’ energy mix does not rely on gas, it depends heavily on large imports of oil which are utilized both for transportation and electricity generation. Furthermore, a stronger-than-currently-expected monetary tightening by the European Central Bank (ECB) might weaken domestic demand, particularly investment activity. In contrast, implementation of investments and reforms in Cyprus’s recovery plan could lead to GDP outcomes more favourable than currently envisaged. Cyprus is expected to receive a substantial amount of funds from the Next Generation EU financial instrument (EUR 0.9 billion in grants and EUR 200 million in loans) during 2021-2026, including the EUR 157 million in pre-financing received in 2021. These amounts are in addition to the Multiannual Financial Framework funds of EUR 1.0 billion during 2021-2027. The expected exploitation of off-shore gas reserves represents another potential source of growth in the longer term. In general, however, the ratings of Cyprus continue to be constrained by the small size of its service-driven economy, which renders it vulnerable to external shocks. In addition, labour productivity levels of the economy remain clearly below the EU average. According to Eurostat, the level of nominal GDP per person employed in Cyprus amounted only to 82.3% of the EU27 average in 2021.

Fiscal Balances Have Continued to Improve Markedly But Are Exposed to Downside Risks

Fiscal balances have recovered strongly from the COVID-19 shock. The general government budget deficit narrowed to 1.7% of GDP in 2021 from 5.8% in 2020 as the strong economic growth rebound over the past year led to a marked increase in tax revenues. Total general government revenues rose by a large 17.0% in 2021, driven by higher revenues from VAT and income taxes. Recent data suggest that budgetary outcomes have continued to improve markedly over the past months. According to interim figures (on a cash basis), the general government registered a surplus of EUR 142 million (0.6% of GDP) during the first seven months of 2022 compared to a deficit of EUR 711 million (3.2% of GDP) during the same time period in 2021, due to an increase in nominal tax revenues and lower COVID-19-related budgetary pressures. The total fiscal cost of COVID-19 support measures is expected to decrease to 0.4% of GDP in 2022 from 3.0% in 2021 and 3.5% in 2020. Budgetary outcomes in 2022 have so far exceeded the government’s fiscal projections in the Stability Programme of April 2022 which forecast a balanced general government budget in 2022 and a surplus of 0.4% of GDP in 2023.

Going forward, potential headwinds for public finances might arise from high-for-longer energy prices as they might necessitate additional energy-related support measures beyond 2023. Since late 2021, the government has implemented different measures to cushion the population from high energy prices (e.g. reduction of VAT on household electricity bills and a decrease in excise duties on gasoline) which, however, are largely planned to expire in 2022. The fiscal cost of current measures is estimated at a moderate 0.6 % of GDP in 2022. Furthermore, a potential weakening of economic growth dynamics would likely weigh on tax revenues. Fiscal pressures might also arise from the National Health System and the planned expansion of KEDIPES. In order to prevent foreclosures for vulnerable households, KEDIPES is planned to acquire eligible primary residences (market value below EUR 250,000) which have been used as collateral in NPLs, and to let those residences to vulnerable households. While the IMF estimated the fiscal cost of this expansion at an upper bound of 3.5% of GDP, authorities expect the fiscal cost to be much lower, not least in view of the recent downsizing of the planned expansion. In general, potential future changes to international corporate taxation constitute a risk factor for public finances given Cyprus’s relatively high share of fiscal revenues coming from this source.

The Government Debt-to-GDP Ratio Is High But On A Downward Trajectory

The high, albeit decreasing, public debt ratio continues to be a rating weakness. Public finances have been strongly impacted by the COVID-19 shock but debt dynamics have started to reverse since last year. The COVID-19 shock led to a strong increase in the general government debt-to-GDP ratio to 115.0% of GDP at end-2020 from 91.1% at end-2019, due to a rising budget deficit and a contraction in nominal GDP. Moreover, DBRS Morningstar notes that the strong increase in gross government debt was partly driven by a strong increase in government cash buffers from 4.1% of GDP at end-2019 to 16.7% at end-2020. Debt dynamics have started to reverse over the past year with general government debt decreasing to an albeit still high 103.9% of GDP at end-2021 due to improving budgetary developments, a rebound in nominal GDP and a partial utilization of the government’s cash buffer. DBRS Morningstar expects debt dynamics to remain favourable in 2022 due to strong interim budgetary outcomes and a large projected increase in nominal GDP which results both from still strong growth dynamics and a marked increase in the GDP deflator related to high inflationary pressures. The government’s Stability Programme of April 2022 projects general government debt to decrease to 93.9% of GDP at end-2022 and 76.7% at end-2025.

The main risks for public finances emanate from a potential economic shock or a materialisation of contingent liabilities related to the still high level of non-performing loan exposures in the banking system. Furthermore, a-larger-than-currently expected ECB monetary policy tightening might raise funding costs of the government, which had decreased markedly over the past years. The government’s interest burden amounted to a moderate 1.7% of GDP in 2021, down from 3.0% in 2014. In the short-to-medium term, however, risks from rising funding costs are partly mitigated by the government’s still large cash buffer that amounted to 12.9% of GDP in August 2022 and a favourable debt profile, due to the extension of average debt maturities over the past years. The weighted average maturity of government debt stood at 7.7 years in July 2022, up from 4.5 years in December 2012.

Asset Quality Risks of Banks Have Decreased Markedly Over The Past Years But Are Still Higher Than In Most Other EU Countries

The legacy stock of non-performing loans in the banking system from the 2012-2013 crisis remains a credit weakness. Although the NPL ratio has decreased markedly from 46.4% in December 2016 to 11.2% in June 2022, due to sales and write-offs of problem loans, it is still substantially higher than in most other Euro Area economies. The average NPL ratio for Euro Area economies amounted to 3.2% in March 2022. Furthermore, while the impact of COVID-19 on asset quality metrics has so far been limited due to government support measures and a temporary loan moratorium between April 2020 and June 2021, DBRS Morningstar notes that the stock of Stage 2 loans has increased noticeably following the outbreak of the pandemic. Stage 2 loans accounted for 15% of gross loans in June 2022, up from 9% in December 2019. The increase in Stage 2 loans has been driven by exposures towards non-financial corporates and might indicate rising asset quality risks. This accounts for the negative qualitative adjustment to DBRS Morningstar’s “Monetary Policy and Financial Stability” building block assessment. Moreover, a stronger-than-currently-expected monetary tightening by the ECB might also raise asset quality risks, as a large share of domestic loans have a floating interest rate.

In contrast, financial stability is supported by the banking sector’s strong capitalisation which provides a cushion against some weakening in asset quality and continued weak profitability. The average capital adequacy ratio amounted to a high 20.6% in June 2022. Moreover, the banking sector benefits from a very strong liquidity position due to a high stock of domestic deposits, primarily household deposits. The net stable funding ratio of the banking sector amounted to a high 166% in June 2022. The ratings take into account the decrease in private sector debt levels in recent years. Households and non-financial corporates have deleveraged significantly in the aftermath of the 2012-2013 crisis. Private non-financial debt (excl. SPEs) decreased to 172% of GDP in March 2022 from 276% in December 2015 and is now on a similar level than in most other Euro Area economies (Average Euro Area in March 2022: 169%). Furthermore, housing prices have increased at a much slower pace than in most other countries. According to Eurostat, housing price in Cyprus rose by 6.6% between March 2015 and March 2022 compared with an average increase of 44.3% for Euro area economies over the same period.

Current Account Balances Impacted by Rebound In Tourist Arrivals and Rising Oil Import Bill

Over the past two years, the economy’s current account balance has been strongly impacted by the opposing effects of a rebound in tourist arrivals and, more recently, the upswing of global oil prices. In 2021, the current account deficit decreased to an albeit still very large 7.2% of GDP from 10.2% in 2020, related to rising service sector exports, especially tourism. Although tourism service exports continued to increase in 2022, this was more than offset by the strong increase in global oil prices, which drove up the economy’s oil import bill for domestic consumption by 137% (y-o-y) during the first half of 2022. Taking into account this deterioration in Cyprus’ terms of trade, the IMF forecasts the current account deficit to widen to 8.2% of GDP in 2022.

In general, external finances are heavily impacted by Cyprus’ role as a financial sector and the operations of special purpose entities (SPEs) which have limited links to the domestic economy. The impact of SPEs is particularly visible with regard to the economy’s negative net international investment position (NIIP) which amounted to a very large 105.5% of GDP in Q2 2022. When excluding external assets and liabilities held by SPEs, the economy’s negative NIIP decreases to 36.8%. Moreover, DBRS Morningstar notes that the non-SPE economy has undergone a marked external deleveraging over the past years. In terms of net external debt, the non-SPE economy commanded over a net asset position of 32.5% of GDP in Q2 2022 compared to a net debtor position of 22.1% at end 2014. This external deleveraging took place in spite of a substantial widening of the non-SPE current account deficit from 1.4% of GDP in 2017 to 8.3% in 2021. This widening was driven by a large increase in the primary income deficit. The main external financing source of the non-SPE economy over the past years have been inflows of direct investment (primarily equity and real estate). The distortion of the overall NIIP by SPEs underpins a positive qualitive adjustment to the “Balance of Payments” building block.

Ratings Are Supported by Stable Political Environment And Strong Institutions

The political environment in Cyprus is stable and characterized by a high degree of policy predictability. The legislative elections in May 2021 resulted in another minority position in the House of Representatives (HoR) for the liberal-conservative party DISY. Since 2013, DISY- led consecutive governments have pursued sound fiscal policies and sought to address the country’s economic challenges. Going forward, DBRS Morningstar expects the government to implement reforms embedded in 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. In terms of institutional quality, DBRS Morningstar notes that the country’s ranking in World Governance Indicators (e.g. Control of Corruption, Rule of Law) has deteriorated over the past years and is now below the EU average. At the same time, DBRS Morningstar considers the country’s EU membership as an important anchor for institutional quality. 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.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Social (S) Factors
The Social factor Human Capital and Human Rights affects the ratings assigned. Cyprus’s nominal GDP per capita is relatively low at USD 30,846 in 2021 compared with its euro system peers. This factor has been taken into account in the ‘Economic Structure and Performance’ building block.

Governance (G) Factors
Two Governance factors are relevant but do not affect the ratings: (1) Bribery, Corruption and Political Risks, and (2) Peace and Security. Cyprus ranks below the EU average in World Bank’s World Governance indicators such as ‘Rule of Law’ (72.6 percentile rank) and ‘Control of Corruption’ (65.4 percentile rank). These risks are partially mitigated by the country’s membership in the EU which DBRS Morningstar regards as an important anchor for institutional quality. Risks for peace and security emanate from the unresolved nature of the Cyprus conflict. Cyprus has been divided since the 1974 invasion by Turkey, and the internationally recognized Republic of Cyprus does not currently exercise effective control over the northern third of the island. Despite recent efforts, United Nations backed negotiations have not resulted to a solution. DBRS Morningstar currently views the persistence of the political status quo as likely and, therefore, does not expect the Governance factor Peace and Security to impact sovereign credit quality. The two relevant Governance factors are reflected in the ‘Political Environment’ building block.

There were no Environmental factors that had a significant or relevant effect on the credit analysis.

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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (17 May 2022).

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments at: https://www.dbrsmorningstar.com/research/403825.

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/401817/global-methodology-for-rating-sovereign-governments (29 August 2022).

Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings, https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (17 May 2022).

The sources of information used for this rating include Cyprus Ministry of Finance (Stability Programme 2022-2025, April 2022; Fiscal Developments July 2022, Cyprus Recovery and Resilience Plan 2021-2026, May 2021), Public Debt Management Office, Central Bank of Cyprus (Macroeconomic Forecasts of the Central Bank of Cyprus for the Cypriot Economy, September 2022; Economic Bulletin, June 2022; Statistics), Statistical Service of the Republic of Cyprus, European Commission (European Economic Forecast, Summer 2022, July 2022; Post-Programme Surveillance Report Spring 2022, May 2022; Analysis of the Recovery and Resilience Plan of Cyprus, July 2021), European Central Bank, European Banking Authority, Eurostat, Social Progress Imperative (2022 Social Progress Index), OECD, IMF (Cyprus: 2022 Article IV Consultation, June 2022; World Economic Outlook April 2022; International Financial Statistics), World Bank, BIS, International Energy Agency, 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.

The conditions that lead to the assignment of a Negative or Positive trend are generally 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: https://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/403789.

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

Lead Analyst: Yesenn El-Radhi, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: 12 July 2013
Last Rating Date: 8 April 2022

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