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 improved markedly over the past year. The general government budget balance turned into a surplus of 2.3% of GDP from a deficit of 1.7% in 2021, driven by a large decrease in public COVID-19 support measures. In addition, nominal tax revenues were boosted by high inflation and strong economic growth with real GDP expanding by 5.6% in 2022. These favourable fiscal and economic growth dynamics contributed to a marked decline in the government debt-to-GDP ratio to an albeit still high 86.5% in 2022 from 101.0% in 2021. In DBRS Morningstar’s view, maintaining this downward trend in debt metrics is key for raising the upward pressure on the rating.

Looking ahead, DBRS Morningstar expects the new government to remain committed to fiscal prudence. Furthermore, future economic growth dynamics are likely to be supported by the opening of large-scale tourist facilities and inflows of Next Generation EU funds. At the same time, DBRS Morningstar notes that the economic and fiscal outlooks are exposed to important downside risks such as a further escalation of the conflict in Ukraine and the recent marked increase in global financial fragility. While the resilience of the large domestic banking sector to an international financial shock is supported by very strong liquidity buffers, a potential further increase in global financial volatility might weaken external and internal demand in relation to the Cypriot economy and, as a result, weigh on tax revenues. A higher-than-currently expected slowdown in economic growth might dampen recent favourable government debt dynamics. Apart from a potential growth shock, risks for debt dynamics might emanate from a potential materialisation of contingent liabilities in the banking sector 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 a lasting strong fiscal performance leading to a further reduction in the public debt ratio; (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 Remained Strong In 2022 But Will Likely Moderate Over The Next Years

Economic growth dynamics remained strong over the past year. Real GDP expanded by 5.6% in 2022 after growing by 6.6% in 2021. Growth was driven by a strong rebound in tourism from the COVID-19 shock. Tourist arrivals rose by 65.3% in 2022, reaching 80.5% of 2019 levels, as the shortfall in Russian tourists was offset by higher arrivals from other countries. In addition, real GDP continued to be boosted by rapid growth in the information and communication (ICT) sector which has accelerated sharply since 2016. Between 2016 and 2022, real gross value added in the ICT sector rose by an annual average of 17.1% as several foreign ICT companies relocated operations to Cyprus not least as a result of different policy measures (e.g. tax incentives). On the demand side, growth was driven by private consumption and gross fixed capital formation which rose by 7.7% and 6.6%, respectively. Private consumption was supported by pent-up demand of households for services, employment growth and government support measures which cushioned the detrimental impact of energy price inflation.

Looking ahead, economic growth dynamics are expected to moderate as some of temporary growth drivers such as pent-up demand of households for services are expected to fade. At the same time, growth is likely to benefit from continued, albeit less rapid, increases in tourist arrivals due to the completion of several new large-scale tourist facilities. In addition, Cyprus is expected to receive Next Generation EU grants to a total amount of EUR 790 million (2.9 % of nominal GDP 2022) during 2023-2026 which, together with cohesion funds from the EU’s current long-term budget, will support domestic investment activity. CBC forecasts real GDP growth at 2.6% in 2023 and 3.0% in 2024. The main downside risks for the growth outlook are an escalation of the military conflict in Ukraine and higher global financial fragility which would likely weigh on external and internal demand. In the long-term, the expected exploitation of off-shore gas reserves represents an important potential source of growth. 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 below the EU average. According to Eurostat, the level of nominal GDP per person employed in Cyprus amounted only to 87.2% of the EU27 average in 2022.

Fiscal Balances Improved Markedly in 2022

Fiscal balances in 2022 have improved more rapidly than expected at the time of our previous review. The general government budget balance turned into a surplus of 2.3% of GDP in 2022 from a deficit of 1.7% in 2021, driven by a strong increase in tax revenues and one-off factors such as a large decrease in COVID-19 support measures. Total revenues rose by 14.5%, clearly exceeding the 4.1% increase in total expenditure, as nominal tax revenues were boosted by very strong economic activity and high inflation. Furthermore, fiscal accounts benefitted from a decrease in the overall scale of fiscal support measures. While the government adopted energy support measures (e.g. electricity subsidies for households and businesses) to the amount of 0.8% of GDP in 2022, the latter impact was clearly outweighed by the large decrease in Covid-19 support measures from 3.0% of GDP in 2021 to just 0.1% in 2022.

Going forward, the government’s 2023 budget targets surpluses of 1.7% of GDP in 2023 and 2.3% 2024 based on the expectation of still strong, albeit decelerating, tax revenue growth and a phasing-out of energy support measures. While the draft budget had been adopted by the previous government, DBRS Morningstar expects the new government to continue to pursue prudent fiscal policies. Moderate budgetary pressures are likely to emanate 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. DBRS Morningstar understands that the fiscal cost for the expansion of KEDIPEs which is estimated at a total of around 0.7% of GDP for the years 2023 and 2024 has so far not been incorporated in the government’s budgetary projections. An important downside risk for fiscal accounts is a stronger-than-currently expected weakening of economic activity which would likely weigh on tax revenues. 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. Corporate income tax revenues amounted to a large 6.5% of GDP in 2021 compared to an average of 3.1% for OECD countries.

Government Debt Dynamics Have Remained Favourable Over The Past Year

The public debt ratio has decreased markedly in 2022 due to last year’s fiscal surplus and very high nominal GDP growth. General government debt declined to a still high 86.5% of GDP in 2022 from 101.0% in 2021. Going forward, the government’s draft budget 2023 projects a decrease in general government debt to 76.5% in 2024. The main risks for public finances emanate from a potential economic shock or a materialisation of contingent liabilities in the large domestic banking sector whose total assets amounted to 275% of GDP in September 2022. Furthermore, the recent increase in interest rates – if prolonged – might raise funding costs of the government, which had decreased markedly over the past years. The government’s interest burden amounted to a moderate 1.5% of GDP in 2022, down from 3.3% in 2014. In the short-to-medium term, however, risks from rising funding rates are mitigated by 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 7.3 years in 2022, up from 4.5 years in 2012. Furthermore, potential short-term funding risks are mitigated by the government’s still large cash buffer that amounted to 9.7% of GDP in December 2022 and covered around 68% of total debt redemptions during 2023 and 2024.

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 9.5% in December 2022 mainly 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 of Euro Area economies stood at 2.9% in September 2022. Going forward, pockets of vulnerability might emerge from the recent strong increase in interest rates which will raise the debt service burden of households and companies as most domestic loans have floating interest rates. Furthermore, DBRS Morningstar notes that the stock of Stage 2 loans, although decreased, continues to be markedly above pre-pandemic levels. Stage 2 loans accounted for 12% of gross loans in December 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.

In contrast, financial stability is supported by the banking sector’s strong capitalisation which has improved over the past years. The average Tier 1 capital ratio amounted to a strong 20.6% in September 2022 compared to 15.9% in December 2016. Moreover, the banking sector has built up very strong liquidity buffers over the past years as a large inflow in resident deposits from households and corporates was primarily channelled into banks’ own cash holdings. Cash and deposits accounted for 37% of total assets in September 2022. In contrast, the relative size of the domestic loan portfolio has decreased due to a deleveraging of households and corporates in the aftermath of the 2012-2013 crisis. Private non-financial debt (excl. SPEs) decreased to 169% of GDP in September 2022 from 282% in March 2015 and is now on a similar level than in most other Euro Area economies.

Current Account Deficit Has Widened Markedly But Has Largely Been Financed By Non-Debt Financial Inflows

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 106.7% of GDP in Q3 2022. When excluding external assets and liabilities held by SPEs, the economy’s negative NIIP decreases to 38.6%.

The current account deficit of the non-SPE economy has widened markedly over the past few years. Between Q4 2021 and Q3 2022, the current account deficit amounted to a very large 10.2% of GDP compared to just 0.5% in 2016. This sharp widening was caused by widening deficits in the goods balance (Q4 2021-Q3 2022: 21.3%) and the primary income balance (7.2%) which clearly offset the rising surplus in the services balance (19.6%). While the widening current account deficit raises external vulnerabilities, this is partly mitigated by the fact that it has been primarily financed by non-debt FDI inflows (primarily equity corporates and real estate). DBRS Morningstar understands that the widening of the primary deficit and the concurrent increase in equity FDI inflows is partly related to the retaining of earnings at foreign subsidiaries in Cyprus.

Ratings Are Supported by Stable Political Environment And Strong Institutions

The presidential elections in February 2023 were won by Nikos Christodoulides who had served as a Minister of Foreign Affairs in the previous government but ran as an independent candidate in the recent election. Although his candidacy was not backed by the countries’ two largest political parties DISY and AKEL, DBRS Morningstar expects no major change in policy direction under the new government. This applies particularly with regard to fiscal policy and the reforms embedded in Cyprus’s recovery plan, which aim 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 30,957 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. https://www.dbrsmorningstar.com/research/412133.

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). In addition, DBRS Morningstar uses 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) in its consideration of ESG factors.

The sources of information used for this rating include Cyprus Ministry of Finance (Draft Budgetary Plan 2023, October 2022; Fiscal Developments January 2023), Public Debt Management Office (Medium-Term Public Debt Management Strategy 2023-2025, October 2022), Central Bank of Cyprus (Macroeconomic Forecasts of the Central Bank of Cyprus for the Cypriot Economy, March 2023; Economic Bulletin, December 2022; Statistics), Statistical Service of the Republic of Cyprus, European Commission (Commission Opinion on the Draft Budgetary Plan of Cyprus, 22 November 2022; European Economic Forecast. Winter 2023, February 2023; Analysis of the Recovery and Resilience Plan of Cyprus, July 2021), European Central Bank, European Banking Authority, Eurostat, European Environment Agency, Social Progress Imperative (2022 Social Progress Index), OECD, IMF (Cyprus: 2022 Article IV Consultation, June 2022; World Economic Outlook October 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/412132.

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: 7 October 2022

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