Morningstar DBRS Confirms Republic of Cyprus at BBB (high), Stable Trend

DBRS Ratings GmbH (Morningstar DBRS) confirmed the Republic of Cyprus’ Long-Term Foreign and Local Currency – Issuer Ratings at BBB (high). At the same time, Morningstar DBRS confirmed the Republic of Cyprus’ Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trend on all ratings remains Stable.

KEY CREDIT RATING CONSIDERATIONS

The Stable trend balances favourable economic and fiscal developments against important downside risks. The Cypriot economy benefitted from comparatively strong growth dynamics over the past year with real GDP expanding by 2.5%, aided by robust private consumption and investment activity. These favourable economic developments bolstered fiscal performance and contributed to a further decrease in the public debt-to-GDP ratio. The general government budget surplus rose to 2.9% of GDP in 2023 from 2.4% in 2022 as a large increase in public revenues more than offset an upswing in spending. General government gross debt declined to 77.4% of GDP in 2023 from 85.6% in 2022 on the back of last year’s fiscal surplus and high nominal GDP growth. Looking ahead, economic developments are likely to remain favourable, underpinned by a further rebound in real wages and still strong investment. At the same time, the economy is exposed to downside risks such as an escalation of the military conflict in Ukraine and a prolonged disruption in trade in the Red Sea. A potential materialization of such downside risks constitutes a risk factor for the fiscal outlook as it would weigh on government revenues and raise spending pressures.

Cyprus’ BBB (high) 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, Morningstar DBRS continues to view the country’s EU membership as an important anchor for institutional quality. On the other hand, the credit ratings of Cyprus continue to be constrained by the small size of its service-driven economy, which renders it vulnerable to external shocks. Cyprus also faces significant challenges due to a legacy stock of NPLs in the banking sector and the economy’s still comparatively low level of labour productivity.

CREDIT RATING DRIVERS

The credit 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 credit 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 or rising budgetary pressures; (2) the materialisation of large contingent liabilities particularly from the large domestic banking sector.

CREDIT RATING RATIONALE

Economic Outlook is Favourable but Exposed to Downside Risks

Economic growth compared favourably with most other euro area countries over the past year. Real GDP expanded by 2.5% in 2023 - compared to a growth rate of just 0.4% for the entire euro area – on the back of robust private consumption and gross fixed capital formation. On the production side, growth was driven by a further rebound in tourist arrivals and a continued expansion of information and communications technology (ICT) industries whereas economic activity in business services was weighed down by a step-up of financial sanctions on Russia in spring 2023. The economic outlook remains favourable. Private consumption is likely to benefit from a further rebound in real wages and solid employment growth. Furthermore, investment activity is projected to be bolstered by the inflow of Next Generation EU funds and several major investment projects particularly in the tourism and residential real estate sectors. The Central Bank of Cyprus (CBC) forecasts real GDP growth to strengthen moderately to 2.6% in 2024 and 3.1% in 2025. At the same time, the growth outlook is exposed to important downside risks such as an escalation of the military conflict in Ukraine and a prolonged disruption in trade in the Red Sea.

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. The most important industries are trade, tourism, financial and business services and real estate. In addition, 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). However, labour productivity levels of the economy remain below the EU average notwithstanding strong economic growth dynamics in recent years. According to Eurostat, the level of nominal GDP per person employed in Cyprus amounted to only 87.6% of the EU27 average in 2022.

General Government Budget Posted a Large Surplus in 2023 on the Back of Strong Revenue Growth

Fiscal performance further improved over the past year. The general government budget surplus rose to 2.9% of GDP in 2023 from 2.4% in 2022 on the back of strong revenue growth. Total revenues increased by a large 11.4% in 2023 as favourable economic growth and labour market developments bolstered tax revenues and social security contributions. This large increase in revenues more than offset the upswing in nominal expenditure by 10.3%. The latter increase mainly resulted from the partial indexation of public wages and public pensions to high inflation in the preceding year, rising expenditure by the National Health Service and higher public investment. The fiscal outlook is projected to remain favourable as public revenues are likely to benefit from still strong economic growth. The government’s draft 2024 budget published in October 2023 forecasts general government surpluses of 2.8% of GDP both in 2024 and in 2025.

Moderate budgetary pressures are likely to emanate from the revision of the cost of living allowance which leads to a larger automatic adjustment of public sector wages and public pensions to inflation, deficits of the State Health Organization and from the 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. Morningstar DBRS understands that the fiscal cost of the expansion of KEDIPES has so far not been incorporated into the government’s budgetary projections. The materialization of economic downside risks constitutes an important risk factor for the fiscal outlook as weaker-than currently economic growth dynamics would weigh on government revenues. In general, potential future changes to international corporate taxation are 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 6.6% of GDP in 2022 compared to an average of 3.4% for OECD countries.

Public Debt is on a Downward Path

The government debt-to-GDP ratio continued to decline over the past year. General government gross debt decreased to 77.4% of GDP in 2023 from 85.6% in 2022 on the back of last year’s fiscal surplus and 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 draft budget 2024 forecasts general government debt to decline to a moderate 69.5% 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 modestly to 1.4% 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 7.0 years in December 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 9.5% of GDP in December 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 263% of GDP in December 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. In addition, banks’ liquidity positions benefit from very large cash balances. 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 7.9% in December 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 2.7% in September 2023. Looking ahead, pockets of vulnerability might emerge from the strong increase in interest rates which has raised the debt service burden of households and companies as most domestic loans have floating interest rates. The average interest rate on outstanding loans rose to 4.6% in January 2024 from 2.5% in June 2022 for households and to 5.8% from 3.0% for non-financial corporates over the same time period. Morningstar DBRS takes a conservative approach to the financial risks faced by the banking sector and applies a negative qualitative adjustment to the ‘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 96.9% of GDP in Q3 2023. When excluding external assets and liabilities held by SPEs, the economy’s negative NIIP decreases to 34.7%. The current account deficit of the non-SPE economy widened markedly over the past years on the back of a widening primary deficit. Between Q4 2022 and Q3 2023, the current account deficit (excluding SPEs) amounted to a very large 9.1% of GDP compared to just 0.5% in 2016. The primary income deficit widened to 7.9% of GDP from 2.2% during the same time period. 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 200% of GDP in September 2023 from 310% of GDP in December 2016. The distortion of the overall NIIP by SPEs underpins a positive qualitive adjustment to the “Balance of Payments” building block.

Credit 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, Morningstar DBRS 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, Morningstar DBRS 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), Morningstar DBRS currently assumes that the chances of a significant breakthrough remain limited.

ENVIRONMENTAL, SOCIAL, AND 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 34,791 in 2023 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’ (68.9 percentile rank) and ‘Control of Corruption’ (66.0 percentile rank). These risks are partially mitigated by the country’s membership in the EU which Morningstar DBRS 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. Morningstar DBRS 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 Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (23 January 2024), https://dbrs.morningstar.com/research/427030/morningstar-dbrs-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://dbrs.morningstar.com/research/430021/.

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 (06 October 2023), https://dbrs.morningstar.com/research/421590/global-methodology-for-rating-sovereign-governments. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings, https://dbrs.morningstar.com/research/427030/morningstar-dbrs-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://dbrs.morningstar.com/about/methodologies.

The sources of information used for this credit rating include Cyprus Ministry of Finance (Draft Budgetary Plan 2024, October 2023), Public Debt Management Office, Central Bank of Cyprus (Economic Bulletin, December 2023; Statistics), Statistical Service of the Republic of Cyprus, European Commission (Commission Opinion on the Draft Budgetary Plan of Cyprus, 21 November 2023; European Economic Forecast, Autumn 2023, November 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 (2024 Social Progress Index), OECD, IMF (Cyprus: 2023 Article IV Consultation, June 2023; World Economic Outlook October 2023; International Financial Statistics), World Bank, BIS, International Energy Agency, Haver Analytics. Morningstar DBRS considers the information available to it for the purposes of providing this credit rating to be of satisfactory quality.

Morningstar DBRS 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. Morningstar DBRS’ outlooks and credit ratings are under regular surveillance.

For further information on Morningstar DBRS 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 Morningstar DBRS 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://dbrs.morningstar.com/research/430020/.

This credit 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, Global Sovereign Ratings
Initial Rating Date: July 12, 2013
Last Rating Date: September 29, 2023

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