Morningstar DBRS Upgrades Republic of Cyprus to A (low), Trend Remains Positive

DBRS Ratings GmbH (Morningstar DBRS) upgraded the Republic of Cyprus' (Cyprus) Long-Term Foreign and Local Currency - Issuer Ratings from BBB (high) to A (low). The trend on all Long-Term ratings remains Positive. At the same time, Morningstar DBRS confirmed 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 upgrade and the Positive trend reflect the sharp decrease of the public debt burden in recent years and Morningstar DBRS' expectation that public debt metrics will continue to materially improve over the next years. The general government debt-to-GDP ratio declined from 96.5% in December 2021 to 69.7% in September 2024, driven by large budgetary surpluses and high rates of nominal GDP growth. Looking ahead, the European Commission (EC) forecasts general government debt to decrease to 56.7% of GDP in 2026 as economic and fiscal developments are projected to remain favourable. Economic growth is likely to continue to benefit from robust private consumption, rising service exports and strong construction investment over the next few years. While, like other European Union (EU) countries, the outlook is exposed to downside risks such as an escalation of geopolitical and global trade tensions, the Cypriot economy is less vulnerable to the direct impact of rising U.S. tariffs on EU goods imports than most other EU countries given the relatively small size of the manufacturing sector.

Fiscal performance is projected to remain very strong with the EC forecasting the general government budget surplus to average 2.7% of GDP in 2025 and 2026 which compares favourably not only with other Euro area countries but also with Cyprus' past fiscal outcomes prior to the pandemic. In terms of improved fiscal outcomes, Morningstar DBRS notes that the country's fiscal accounts benefit not only from favourable cyclical developments but also from structural improvements on the revenue side in recent years. This, in turn, would help to offset potential spending pressures arising from the roll-out of the rent-to-mortgage scheme and the implementation of large-scale energy projects as well as from pressures to step up defence spending. Cyprus' credit profile also benefits from an improved financial condition of domestic banks as the strong increase in capital buffers over the past two years has strengthened banks' resilience. Improvements in the "Debt and Liquidity" and "Monetary Policy and Financial Stability" building blocks are the key factors for the upgrade.

Cyprus' A (low) 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, the economy's still comparatively low level of labour productivity and the large current account deficit of the non-SPE economy.

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 further 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 our expectations for the downward path of the public debt ratio materially change. 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 sizeable domestic banking sector.

CREDIT RATING RATIONALE

Economic Growth Expected to Remain Comparatively Strong on the Back of Robust Domestic Demand

The Cypriot economy continued to grow at a comparatively strong pace over the past year, underpinned both by external and domestic demand. Real GDP expanded by 3.4% in 2024 compared with a growth rate of 0.9% for the entire Euro area. Growth was bolstered by rising service exports particularly with regard to financial services and charges related to the use of intellectual property. Moreover, private consumption grew at a strong, albeit decelerating, pace, driven by real wage gains and continued employment growth particularly of foreign labour. In addition, domestic investment expanded particularly regarding residential and non-residential construction. Looking ahead, economic growth dynamics are projected to remain strong. The Central Bank of Cyprus (CBC) forecasts real GDP to expand by 3.2% in 2025 and by 3.1% in 2026 on the back of robust domestic demand. 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. Similar to other countries, the economic outlook is exposed to downside risks such as an escalation of geopolitical tensions. A potential broad-based increase in US tariffs on goods imports from EU countries is likely to have a smaller direct impact on Cyprus than on several other EU countries due to the service-driven nature of the Cypriot economy. That said, a large global goods trade shock would likely impact the economy in an indirect manner by weighing on external demand from trading partner economies for Cypriot service sector exports.

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. This applies particularly to tourism and large capital inflows as the latter have been a key driver of construction-related investment activity in recent years due to the economy's comparatively low savings rate. Gross value added in the information and communications technology (ICT) sector has increased sharply since 2016 as several foreign ICT companies relocated operations to Cyprus not least because of different policy measures (e.g. tax incentives). While, however, the share of the ICT sector at total gross value added more than doubled from 4.8% to 11.1% between 2015 and 2024, the increase of employment in the ICT sector was much less pronounced, accounting for 4.2% of total domestic employment in 2024, up from a share of 2.7% in 2015. However, 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 importance 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' credit profile is supported by the government's very strong fiscal performance in recent years. The general government budget surplus amounted to 4.5% of GDP in 2024, up from 2.0% in 2023. The large increase in the budget surplus can partly be ascribed to a one-off factor as fiscal results in 2023 were adversely impacted by a retroactive one-time payment to the amount of 1.1% of GDP to the pension fund of public sector employees. Apart from the latter, however, fiscal performance also benefited from continued strong revenue growth particularly regarding income taxes from companies and, to a lesser extent, from households. Total government revenues rose by 7.8% in 2024. As laid out in the commentary Cyprus: Public Finances Benefit from Strong Revenue Growth, the improvement in fiscal outcomes over the past years primarily results from structural improvements on the revenue side as relocations of foreign companies to Cyprus in recent years have widened the corporate income tax base. Furthermore, the increase in the social security contribution rate from January 2024 onwards strengthens the financial position of the social security system.

Looking ahead, fiscal developments are projected to remain favourable. The government's medium-term fiscal structural plan from October 2024 forecasts the general government budget surplus at 2.7% of GDP in 2025 and 2.6% in 2026. Over the next few years, government accounts are likely to continue to benefit from strong, albeit decelerating, public revenue growth. The structural improvements on the revenue side would help the government cope with potential spending pressures arising from the roll-out of the rent-to-mortgage scheme, higher defence spending pressures and higher-than-planned costs for large-scale energy projects such as the LNG terminal and the Great Sea Interconnector. 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 6.3% of GDP in 2023 compared to an average of 3.3% for EU countries.

The Government's Debt Burden Is Projected to Continue to Decrease Over the Medium-Term

The public debt-to-GDP ratio has been on a clear downward trend over the past years on the back of large budgetary surpluses and high nominal GDP growth. General government gross debt stood at 69.7% of GDP in September 2024, down from 113.6% in December 2020. Looking ahead, continued budgetary surpluses and favourable debt dynamics are projected to lead to a further marked decrease in the debt ratio. The government's medium-term fiscal structural plan forecasts general government debt to decrease to 64.1% of GDP in 2025 and to 58.8% in 2026. The projected decrease in outstanding debt helps to offset the impact of higher interest rates on the government's interest burden. The EC forecasts general government interest expenditure to decline modestly to 1.0% of GDP in 2026 from 1.2% in 2024. 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 27.5% of outstanding general government gross debt in September 2024.

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 to the amount of 34% of GDP as large social security surpluses have been utilized for financing central government budget deficits in the past. While the utilisation 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 materialisation 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 8.2% of GDP in December 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 196% of GDP in December 2024 and which is characterised by a high degree of concentration. Currently, these risks are partly mitigated by the strong financial condition of the banking sector.

Capital Buffers of Domestic Banks Have Increased Markedly over the Past Two Years

The financial condition of the domestic banking sector has improved and is now assessed as strong. This reduces risks stemming from contingent liabilities. Capital buffers of domestic banks have increased considerably over the past two years as a comparatively large increase in net interest income boosted banks' retained earnings. The average CET 1 ratio of Cypriot banks rose to 22.0% in Q3 2024 from 17.4% two years earlier whereas the average improvement in CET 1 across EU banks was more modest with an increase to 16.3% from 15.0% over the same period. 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 6.2% in December 2024 mainly due to sales and write-offs of problem loans, it is still clearly higher than in most other Euro area economies. The average NPL ratio of Euro area economies stood at 2.3% in September 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. Even though interest rates have started to decrease, they remain on a much higher level than prior to the recent monetary tightening cycle. At the same time, Morningstar DBRS notes that early warning indicators such as Stage 2 loans do so far not point to a renewed increase in NPLs. Moreover, the strong increase in capitalisation levels provides banks with buffers to absorb some potential weakening in asset quality.

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 regarding the economy's negative net international investment position (NIIP) which amounted to 84.6% of GDP in Q3 2024. When excluding external assets and liabilities held by SPEs, the economy's negative NIIP decreases to 30.3%. At the same time, strong domestic demand within the non-SPE economy has raised the current account deficit markedly over the past years. Although net service exports increased strongly related to 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 outflows 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 and capital injections into companies. Instead, gross external debt (excluding SPEs) declined to 180% of GDP in September 2024 from 325% 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 assessments.

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 regarding 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 reduce corruption, and to boost the economy's green and digital transition. The successful 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 the Worldwide 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: The Human Capital and Human Rights (S) factor is a significant consideration for Cyprus' ratings. Cyprus' nominal GDP per capita, estimated at USD 37,767 in 2024, is relatively low when compared to other Euro area countries. This factor has been taken into account in the `Economic Structure and Performance' building block.

Governance (G) Factors

The following Governance factor(s) had a relevant effect on the credit analysis: 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 Rule of Law' (71.7 percentile rank) andControl of Corruption' (62.7 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/450394.

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 these credit ratings include Cyprus Ministry of Finance (Medium-Term Fiscal Structural Plan for the Period 2025-2028, October 2024), Public Debt Management Office (Annual Report Public Debt Management 2023, April 2024), Central Bank of Cyprus (Macroeconomic Forecasts, March 2025; 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, Autumn 2024, November 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 (2025 AlTi Global Social Progress Index), OECD, IMF (Cyprus: 2024 Article IV Consultation, May 2024; World Economic Outlook October 2024; International Financial Statistics, Financial Soundness Indicators), World Bank, BIS, International Energy Agency, and Macrobond. 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 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://www.dbrsmorningstar.com/research/450393.

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: 12 July 2013
Last Rating Date: 20 September 2024

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