DBRS upgrades rating to B, ‘stable’ trend, warns that challenges remain
DBRS Inc., the fourth-largest credit rating agency in the world, has upgraded the longterm foreign and local currency issuer ratings for the Republic of Cyprus from B (low) it issued in December 2014 to B as “strong fiscal performance and signs of economic stabilisation have helped to ease near-term concerns regarding the fallout from the financial crisis”.
The Canadian rating agency, one of only four to receive “external credit assessment institution” from the European Central Bank has also upgraded the short-term foreign and local currency issuer ratings from R-5 to R-4, thus rising from “highly speculative credit quality” to “speculative credit quality” on commercial paper and short term debt.
DBRS said that the trend on all ratings is ‘stable’ as “Cypriot authorities have demonstrated a strong commitment to the troika-supported adjustment programme, and available official financing exceeds Cyprus’ needs. Nonetheless, Cyprus’ B ratings underscore the depth of challenges and continued need for external support. Cyprus remains vulnerable due to high levels of debt, relatively high real interest rates and reliance on external demand to fuel growth.”
Cyprus’ small and relatively undiversified economy will remain heavily dependent on external demand for the foreseeable future. DBRS expects only gradual improvements from efforts to extend the tourist season and remains concerned that competition from other Mediterranean locations may dampen growth in the sector. If growth in tourism and business registrations slows significantly, the economy could face gradually declining output for years to come as the domestic deleveraging process continues. Russian demand is particularly important, though additional shocks from Europe could also have negative effects on Cyprus.
Improvements in fiscal management and in debt and liquidity are the main factors driving the upgrade, the rating agency said, adding that sustained economic and fiscal outperformance could lead to further upward pressure on the ratings.
“Accelerating progress on the resolution of non-performing loans, on privatisation and on steps to encourage foreign investment could enhance growth prospects and also provide support to the ratings. On the other hand, a prolonged period of weak growth, particularly if combined with fiscal policy slippages and higher financing needs, could result in downward pressure on the ratings. External factors, including political developments between Cyprus and Turkey and between the EU and Russia, could also have an impact on prospects for growth and investment in tourism, financial services and the energy sector.”
DBRS said that the EUR 10 bln programme agreed with the European Commission, European Central Bank and International Monetary Fund in 2013 has cushioned the impact of the financial crisis and recession and given Cypriot authorities space to tackle fiscal challenges. Given the Republic’s strong performance under the Eurogroup and IMF programme thus far, Cyprus is expected to forgo a portion of the support available under its existing programme.
The low tax environment remains attractive to foreign corporations. Business owners from Russia and other eastern European countries continue to incorporate in Cyprus for tax and other reasons in spite of the losses imposed on foreign bank depositors in 2013. Although Cyprus’ advantages are not unique and could be eroded by external competitors or by regulatory changes in creditor countries, DBRS expects the business services sector to remain an i mportant source of employment and income.
On tourism, the rating agency said that rising household incomes in Eastern Europe should continue to provide a stable source of growth in tourist arrivals. The declining rouble and Russian recession have had a significant impact on overall receipts, but this has largely been offset by increased tourism from the UK and other countries. Tourism will remain highly seasonal and vulnerable to economic downturns, but focused and pragmatic public and private sector efforts to expand the island’s appeal could generate long-term benefits.
Over the next few decades, exploitation of offshore natural gas deposits could provide a major new source of income for the economy. Although exploration efforts have slowed due to global market conditions, proven gas reserves should still bring in a considerable amount of new revenue for the government. If managed prudently, the associated financial inflows could help to significantly reduce Cyprus’ exposure to shocks. In addition, related investment and lower domestic energy costs could have ancillary benefits for the economy. The pace of development of the gas sector could nonetheless be affected by relations with Turkey.
In spite of these strengths, Cyprus faces several near-term challenges. General government debt appears to have peaked at 108.2% in 2014. Although the fiscal adjustment appears largely complete at this stage, continued fiscal discipline and stronger economic growth will be essential to bring debt down to more manageable levels over time. Gross financing requirements through mid2016 can be comfortably met through official financing, and the government has taken advantage of lower market interest rates to extend debt maturities and minimise financing needs in the post-program period (2016-18). A prolonged deterioration in market conditions could nonetheless present significant challenges given Cyprus’ heavy reliance on external funding.
Private sector debt ratios are also at historically high levels and suggest that growth will be constrained by further deleveraging. Household and corporate balance sheets have been damaged in the crisis, including through the bail-in of uninsured depositors.
Real estate prices are still declining, albeit at a more moderate pace, and the ultimate impact of the decline on household wealth, domestic savings, and bank solvency is not yet clear. Financial institutions will need to significantly reduce outstanding domestic credit or identify significant new sources of funding.