DBRS Morningstar Upgrades Republic of Cyprus to BBB (high), Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) upgraded the Republic of Cyprus’ Long-Term Foreign and Local Currency – Issuer Ratings from BBB to BBB (high). At the same time, DBRS Morningstar upgraded the Republic of Cyprus’ Short-Term Foreign and Local Currency – Issuer Ratings from R-2 (high) to R-1 (low). The trends on all ratings remain Stable.

KEY CREDIT RATING CONSIDERATIONS
The upgrade is driven by the recent decline in government debt and DBRS Morningstar’s expectation that public debt metrics will continue to improve over the next years. General government gross debt decreased to 86.5% of GDP in 2022 from 101.2% in 2021 and is projected to decline further to 67.3% in 2025, driven by robust economic growth and large primary surpluses. While moderating, economic growth is likely to remain among the strongest in the euro area. Real GDP is forecast to expand by 2.4% in 2023 and by 2.7% in 2024, underpinned by a further increase in tourist arrivals, a continued expansion of information and communications technology (ICT) industries and robust domestic demand. These favourable economic developments, in turn, are likely to bolster tax revenue growth over the next years. In addition, DBRS Morningstar takes the view that the new government will continue to pursue prudent fiscal policies. The government’s stability programme targets primary budget surpluses of 3.2% of GDP in 2023 and 3.7% in 2024. Furthermore, DBRS Morningstar notes that downside risks from global financial fragility, which had risen at the time of our last review in March 2023, have subsided in recent months. While a materialisation of contingent liabilities from the banking sector remains an important downside risk, DBRS Morningstar currently does not expect a lasting reversal of the downward trajectory in debt metrics over the next years. Improvements in DBRS Morningstar’s “Debt and Liquidity” and “Fiscal Management and Policy” building blocks are the key factors for the upgrades.

Cyprus’ BBB (high) ratings and the Stable Trend 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 stock of legacy NPLs in the banking sector and the economy’s still 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.

CREDIT 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 material 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.

CREDIT RATING RATIONALE

Economic Growth Has Moderated but is Likely to Remain Stronger Than in Most Other EU Countries over the Next Years

Economic growth dynamics have decelerated in recent months. Real GDP growth slowed to, an albeit still good, 2.1% on a year-on-year basis in Q2 2023, down from 3.1% in Q1 2023 and 4.6% in Q4 2022, driven by a moderation in private consumption. Furthermore, a new round of financial sanctions on Russia in spring 2023 weighed on economic activity in business services. In contrast, growth continued to benefit from a rebound in tourism. During the first eight months of 2023, total tourist arrivals rose by a large 24.5% on a year-on-year basis. In addition, growth dynamics in the ICT sector remained strong. Economic activity in the ICT sector has increased sharply since 2016 as several foreign ICT companies relocated operations to Cyprus not least as a result of different policy measures (e.g. tax incentives).

Looking ahead, economic growth is projected to strengthen gradually driven by a catch-up in real wages. Furthermore, investment activity is likely to be bolstered by the inflow of Next Generation EU funds and several major investment projects particularly in the tourism sector. The Central Bank of Cyprus (CBC) forecasts real GDP to expand by 2.4% in 2023 and by 2.7% in 2024 which clearly exceeds the growth projections of most other EU countries. The ECB forecasts real GDP growth in the total euro area at just 0.7% in 2023 and 1.0% 2024. An important downside risk for the economy’s growth outlook is an escalation of the military conflict in Ukraine. In general, the ratings of Cyprus continue to be constrained by the small size of its service-driven economy, which renders it vulnerable to external shocks. Furthermore, notwithstanding strong economic growth dynamics in recent years, 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 to only 87.1% of the EU27 average in 2022.

Fiscal Balances Have Improved Markedly and the Outlook is Favourable

Fiscal balances improved markedly over the past year. The general government budget balance turned into a surplus of 2.1% of GDP in 2022 from a deficit of 2.0% in 2021, driven by one-off factors such as a large decrease in COVID-19 support measures and as tax revenues were boosted by high nominal GDP growth. Fiscal developments have remained favourable in recent months on the back of a broad-based increase in tax revenues and social contributions. During the first seven months of 2023, total general government revenues increased by 11.7% on a year-on-year basis, clearly exceeding the increase in total expenditure by 6.5% which resulted largely from higher outlays on public sector wages and social transfers. At the same time, the government adopted two supplementary budgets in 2023 to accommodate for higher current and capital spending. In view of the latter, DBRS Morningstar takes the view that the general government budget surplus in 2023 will be slightly below the target of 2.0% of GDP, which had been set out in the April 2023 Stability Programme.

The fiscal outlook is favourable. DBRS Morningstar expects government revenues to be bolstered by robust growth dynamics in the economy. Moreover, we take the view that the new government will continue to pursue prudent fiscal policies. The Stability Programme projects general government budget surpluses of 2.3% of GDP both in 2024 and in 2025. Moderate budgetary pressures are likely to emanate from the recent revision of the cost of living allowance which leads to a larger automatic adjustment of public sector wages and public pensions to inflation and from 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 of the expansion of KEDIPES has so far not been incorporated into the government’s budgetary projections. 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.

Public Debt is on a Firm Downward Path

The government debt-to-GDP ratio declined markedly over the past year. General government debt decreased to 86.5% of GDP in 2022 from 101.2% in 2021 on the back of last year’s fiscal surplus and very high nominal GDP growth. Looking ahead, continued budgetary surpluses and favourable debt dynamics are projected to lead to a further marked decrease in the debt ratio. The Stability Programme forecasts general government debt to decline to a moderate 67.3% of GDP in 2025. In terms of the government’s interest burden, the projected decrease in outstanding debt helps to offset the impact of the recent increase in interest rates. The European Commission forecasts general government interest expenditure to decline moderately to 1.3% of GDP in 2024 from 1.5% in 2022. The pass-through of higher interest rates has been attenuated by a favourable debt profile following the extension of average debt maturities over the past years. The weighted average maturity of government debt stood at 7.4 years in August 2023, up from 4.5 years in December 2012. Potential short-term funding risks are mitigated by the government’s still large cash buffer that amounted to around 12% of GDP in August 2023. 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 261% of GDP in June 2023.

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

Financial stability is supported by the banking sector’s strong capitalization and very large liquidity buffers. At the same time, the legacy stock of non-performing loans (NPLs) 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 8.7% in June 2023 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 2.5% in March 2023. In DBRS Morningstar’s view, avoiding a renewed suspension of the foreclosure framework would support the resolution of remaining NPLs. Looking ahead, pockets of vulnerability might emerge from the recent strong increase in interest rates which has raised 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 above pre-pandemic levels. Stage 2 loans accounted for 11% of gross loans in June 2023, 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.

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 105.4% of GDP in Q1 2023. When excluding external assets and liabilities held by SPEs, the economy’s negative NIIP decreases to 39.6%. DBRS Morningstar views the marked widening of the current account deficit of the non-SPE economy over the past years as a risk factor. Between Q2 2022 and Q1 2023, the current account deficit (excluding SPEs) amounted to a very large 12.2% of GDP compared to just 0.5% in 2016. This sharp widening was caused by widening deficits in the goods balance (Q2 2022-Q1 2023: 22.5%) and the primary income balance (7.4%) which clearly offset the rising surplus in the services balance (18.4%). 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). Gross external debt (excluding SPEs) declined to an albeit still large 223% of GDP in March 2023 from 310% of GDP in December 2016.

Ratings Are Supported by Stable Political Environment

The political environment in Cyprus is stable. The election of Nikos Christodoulides as president in February 2023 has not led to major policy changes particularly with regard to fiscal policy and the reforms embedded in Cyprus’s recovery plan. These reforms aim to enhance the efficiency of the judicial system and of 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 Human Capital and Human Rights (S) factor is a significant consideration for Cyprus’ ratings. Cyprus’ nominal GDP per capita is relatively low at USD 31,466 in 2022 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 (4 July 2023) at https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/421251/.

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in Euros 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 (29 August 2022) https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments. 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/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

The sources of information used for this rating include Cyprus Ministry of Finance (Stability Programme 2023-2026, April 2023), Public Debt Management Office, Central Bank of Cyprus (Macroeconomic Forecasts of the Central Bank of Cyprus for the Cypriot Economy, September 2023; Statistics), Statistical Service of the Republic of Cyprus, European Commission (Post-Programme Surveillance Report Spring 2023, May 2023; European Economic Forecast, Spring 2023, May 2023; Analysis of the Recovery and Resilience Plan of Cyprus, July 2021), European Central Bank (Macroeconomic Projections for the Euro Area, September 2023), European Banking Authority, Eurostat, European Environment Agency, Social Progress Imperative (2022 Social Progress Index), OECD, IMF (Cyprus: 2023 Article IV Consultation, June 2023; World Economic Outlook April 2023; International Financial Statistics), World Bank, BIS, International Energy Agency, Haver Analytics. national statistical agency, central bank, Ministry of Finance, IMF, World Bank, Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

DBRS Morningstar does not audit the information it receives in connection with the credit 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 credit 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://registers.esma.europa.eu/cerep-publication. For further information on DBRS Morningstar historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at: https://www.dbrsmorningstar.com/research/421250/.

These credit ratings are endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Yesenn El-Radhi, Vice President, Sovereign Ratings,
Rating Committee Chair: Nichola James, Managing Director, Credit Ratings,
Initial Rating Date: July 12, 2013
Last Rating Date: March 31, 2023

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.