Morningstar DBRS Changes Trend on Republic of Cyprus to Positive, Confirms at BBB (high)

DBRS Ratings GmbH (Morningstar DBRS) confirmed the Republic of Cyprus' Long-Term Foreign and Local Currency - Issuer Ratings at BBB (high). The trend on the Long-Term ratings has been changed to Positive from Stable. 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 Short-Term ratings remains Stable.

KEY CREDIT RATING CONSIDERATIONS
The Positive trend reflects Morningstar DBRS' view that public debt metrics are likely to continue to improve. The general government debt-to-GDP ratio decreased from 99.3% in 2021 to 77.4% in 2023. Looking ahead, the European Commission (EC) forecasts general government debt to decline further to 65.4% of GDP in 2025 on the back of strong economic growth and fiscal surpluses. Economic growth is likely to continue to benefit from robust private consumption, rising service exports and strong construction investment over the next few years. The EC forecasts real GDP in Cyprus to grow by an average of 2.9% in 2024 and 2025, compared to a growth rate of 1.1% for the Euro Area. Favourable growth and employment developments, in turn, are projected to bolster tax revenues and social security contributions. Strong revenue growth has been a key driver of fiscal surpluses in recent years. During the first seven months of 2024, general government revenues grew by a large 14.2% on a year-on-year basis, driven by higher income taxes and social contributions which clearly exceeded the 9.4% increase in public spending. Morningstar DBRS takes the view that government accounts are likely to continue to benefit from strong, albeit decelerating, revenue growth which will offset moderate spending pressures arising from rising public wages, ageing-related expenditure and the roll-out of the mortgage-to-rent scheme. The government's stability programme from April 2024 forecasts the general government budget surplus at 2.9% of GDP in 2024 and at 2.8% in 2025.

Cyprus' BBB (high) ratings are supported by a stable political environment, the government's sound fiscal and economic policies in recent years, and a moderate interest burden. 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 Positive trend could be returned to Stable if the downward path in the public debt ratio is less durable than anticipated. 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 Growth Remains Comparatively Strong

The Cypriot economy continued to grow at a comparatively strong pace in recent months. Real GDP expanded by 3.5% on a year-on-year basis during the first half of 2024 compared to a growth rate of just 0.5% for the entire Euro area during the same time period. Growth was driven by robust private consumption, underpinned by a catch-up in real wages and solid employment growth on the back of rising inflows of foreign labour. Furthermore, service exports rose and domestic investment strengthened markedly particularly with regard to residential and non-residential construction. On the production side, growth was bolstered by a further rebound in tourist arrivals, a continued expansion of information and communications technology (ICT) and construction. In addition, business services recovered from a slump in spring 2023 which had resulted from a step-up of financial sanctions on Russia. The economic outlook remains favourable. Private consumption is likely to benefit from further, albeit decelerating, growth in real wages and a continued increase in employment levels. Furthermore, investment activity is projected to be supported by several major investment projects particularly in the tourism and residential real estate sectors and rising inflows of Next Generation EU funds. In June 2024, the Central Bank of Cyprus (CBC) forecasted real GDP to expand by 3.0% in 2024 and by 3.1% in 2025 on an annual basis. In terms of 2024, Morningstar DBRS notes that the annual growth rate is likely to be higher than projected in June given the strong economic growth dynamics during the first half of this year. 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, gross value added 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). While, however, the share of the ICT sector at total gross value added almost doubled from 4.8% to 9.4% between 2015 and 2023, the increase of employment in the ICT sector was much less pronounced, accounting for 3.6% of total domestic employment in 2023, up from a share of 2.7% in 2015. Labour productivity levels of the economy remain below the EU average, notwithstanding strong economic growth dynamics in recent years, which can partly be ascribed to the important role of labour-intensive industries such as tourism. According to Eurostat, the level of nominal GDP per person employed in Cyprus amounted to only 89.2% of the EU27 average in 2023.

Fiscal Developments Are Projected to Remain Favourable Over the Next Few Years on the Back of Strong Revenue Growth

Cyprus' fiscal performance continues to be very strong. After posting a general government budget surplus of 3.1% of GDP in 2023, fiscal developments remained favourable in recent months as government revenues continued to increase at a higher rate than public spending. Total general government revenues rose by 14.2% on a year-on-year basis during the first seven months of 2024 on the back of strong economic growth and labour market developments which bolstered tax revenues and social security contributions. Moreover, social security revenues were raised by an increase in the contribution rate from January 2024 onwards. The large increase in revenues more than offset the upswing in nominal expenditure by 9.4%. The latter increase mainly resulted from the partial indexation of public wages and public pensions to inflation in the preceding year and rising expenditure by the National Health Service. On an annual basis, the government's stability programme update from April 2024 forecasts the general government budget surplus at 2.9% of GDP in 2024 and at 2.8% in 2025. In view of the favourable fiscal developments in recent months, Morningstar DBRS expects the government to post a larger budgetary surplus in 2024 than projected in the stability programme.

Over the next few years, government accounts are likely to continue to benefit from strong, albeit decelerating, revenue growth given the favourable economic outlook. This, in turn, is likely to help the government coping with moderate budgetary pressures arising from rising ageing-related expenditure, deficits of the State Health Organization, the roll-out of the rent-to-mortgage scheme and legal disputes stemming from the construction of the new LNG terminal. Similar to other countries, long-term spending needs on the adaption and mitigation of climate change are likely to be sizeable. 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.

The Public Debt Ratio is on a Downward Path

General government debt metrics improved markedly in recent years. The government debt-to-GDP ratio decreased to 77.4% in 2023 from 99.3% in 2021 on the back of large budgetary surpluses 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 April 2024 stability programme forecasts general government debt to decrease to 65.5% of GDP in 2025. The projected decrease in outstanding debt helps to offset the impact of higher interest rates on the government's interest burden. The European Commission forecasts general government interest expenditure to decline modestly to 1.3% of GDP in 2025 from 1.5% in 2023. In terms of the interest burden, the government continues to benefit from the favourable interest rate on the ESM loan which had been granted to Cyprus in 2013 and which accounted for 27% of outstanding general government gross debt at end 2023.

In general, Morningstar DBRS notes that outstanding intra-government debt, which is cancelled out in general government debt calculations, is large. At end 2023, the central government owed domestic social security funds debt in the amount of 36% of GDP as large social security surpluses have been utilized for financing central government budget deficits in the past. While the utilization of these social security buffers is a cheap and stable source of funding, it also raises downside risks for central government finances in case sustained deficits in the social security system would need to be covered by budgetary transfers. That said, a materialization of these downside risks appears unlikely over the next few years as the social security system is forecast to continue to register surpluses on the back of solid employment growth and the recent increase in social security contribution rates. Potential short-term funding risks are mitigated by the central government's large cash buffer that amounted to 10.7% of GDP in July 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 251% of GDP in June 2024.

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 6.9% in June 2024 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 2.6% in March 2024. 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 4.9% in July 2024 from 2.6% in July 2022 for households and to 5.8% from 3.1% 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 of Non-SPE Economy Is Very Large But Has Primarily 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 94.1% of GDP in Q1 2024. When excluding external assets and liabilities held by SPEs, the economy's negative NIIP decreases to 35.8%. At the same time, the current account deficit of the non-SPE economy has widened markedly in recent years on the back of strong domestic demand. Between Q2 2023 and Q1 2024, the current account deficit (excluding SPEs) amounted to a very large 10.6% of GDP compared to just 0.5% in 2016. Although net service exports increased strongly on the back of rising ICT service exports and, to a lesser extent, a rebound in tourist arrivals, this was more than offset by a marked deterioration in the primary income balance which resulted from higher profit allocated to foreign shareholders. 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 such as foreign purchases of real estate. Instead, gross external debt (excluding SPEs) declined to an albeit still large 194% of GDP in March 2024 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

ESG Considerations had a significant effect on the credit analysis.

Social (S) Factors

The following Social factor had a significant effect on the credit analysis: Human Capital and Human Rights. Cyprus' nominal GDP per capita is relatively low at USD 34,957 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

The following Governance factors had a relevant effect on the credit analysis: (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) andControl 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 relevant or significant 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 Factors in Credit Ratings (13 August 2024) https://dbrs.morningstar.com/research/437781

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/439780.

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 (15 July 2024) https://dbrs.morningstar.com/research/436000. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings https://dbrs.morningstar.com/research/437781 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 (Stability Programme Update 2024-2027, April 2024), Public Debt Management Office (Annual Report Public Debt Management 2023, April 2024), Central Bank of Cyprus (Macroeconomic Forecasts, June 2024; Statistics), Ministry of Labour and Social Insurance (2024 Ageing Report, Cyprus - Country Fiche, December 2023), Statistical Service of the Republic of Cyprus, European Commission (European Economic Forecast, Spring 2024, May 2024; 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: 2024 Article IV Consultation, May 2024; World Economic Outlook April 2024; International Financial Statistics), World Bank, BIS, International Energy Agency, Haver Analytics. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

Morningstar DBRS 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. Morningstar DBRS' outlooks and 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://www.dbrsmorningstar.com/research/439779.

These credit ratings are 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: March 22, 2024

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