DBRS up­grades rat­ing to B, ‘stable’ trend, warns that chal­lenges re­main

Financial Mirror (Cyprus) - - FRONT PAGE -

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.

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