Debt, NPLs, Brexit a major challenge for Cyprus
DBRS Ratings Limited (DBRS) has confirmed the Republic of Cyprus’s longterm foreign and local currency issuer ratings at B and the short-term foreign and local currency ratings at R-4. The trend on all ratings is ‘stable’.
The ratings reflect Cyprus’s Eurozone membership, which has ensured financial support, as well as its attractiveness as a business services centre and a tourist destination, the solid fiscal performance achieved under the economic adjustment programme, and its favourable public debt maturity profile. However, the ratings also underscore the depth of Cyprus’s challenges, given its high levels of public and private sector debt, sizable nonperforming loans, persistent external imbalances and the small size of its relatively undiversified economy.
As economic conditions stabilised in 2015, output returned to growth. The recovery appears likely to strengthen gradually, supported by tourism, stabilisation in the housing sector and improving conditions in the labour market. The Stable trend reflects DBRS’s view that the economic recovery, while expected to be broadly steady, could face some risks in the near term given its reliance on external demand.
Conditions in the global economy could prove less supportive and volatility in financial markets could intensify. In particular, a UK vote to leave the EU could affect the recovery of the Cypriot economy given its strong trade and financial links to the UK.
Cyprus benefits significantly from its membership in the Eurozone. Policy measures implemented in the process of EU accession in 2004 and adoption of the Euro in 2008, and more recently, under the economic adjustment programme, have helped strengthen domestic institutions and enhance Cyprus’s attractiveness as a business centre and tourist destination. EU budget transfers and long-term infrastructure financing from the European Investment Bank also contribute to investment.
Moreover, in March 2016, Cyprus concluded the three-year programme agreed with the European Commission, the European Central Bank and the IMF. The IMF contributed EUR 1 billion, while the EU provided EUR 6.3 billion of the EUR 9 billion initially agreed. The programme allowed Cyprus to consolidate its public finances and restructure its banking sector.
The attractiveness of Cyprus as a business services centre is not only supported by strengthened institutions and policies, but also by its low corporate tax environment. Although Cyprus’s advantages could be eroded by external competitors or by regulatory changes in creditor countries, DBRS expects the business services sector to remain an important source of employment and income for the economy. Cyprus has also taken advantage of its geographic location that makes the island an attractive tourist destination for Europeans.
Cyprus’s robust fiscal performance in recent years provides additional support to the ratings. The government achieved a relatively quick improvement in the budget position, with the headline fiscal deficit declining from 5.8% of GDP in 2012 to 1.0% in 2015 and the primary deficit shifting to a surplus of close to 2%. Fiscal management has also been strengthened, which together with some privatisations, should help maintain the fiscal adjustment. The fiscal position is expected to continue to improve over the coming years.
Public debt maturity structure is also favourable. The government has benefited from lower market interest rates and extended debt maturities, thus reducing refinancing risks. The average debt maturity was 8.5 years at the end of 2015. In particular, ESM loans – with a weighted average maturity of nearly 15 years - are not set to be repaid until 2025.
Nevertheless, Cyprus faces several credit challenges. General government debt is estimated to have peaked at 108.9% of GDP in 2015. 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. Moreover, a prolonged deterioration in market conditions could present significant challenges given Cyprus’s reliance on external funding.
Private sector debt ratios are also at historically high levels and suggest that growth will be constrained by deleveraging. Household and corporate balance sheets have been damaged in the crisis, through the bail-in of uninsured depositors and the fall in real estate prices. At the same time, Cypriot banks’ non-performing loans for households and corporations are extremely high, at around 55% of total loans, although important efforts have been taken to speed the resolution of NPLs.
External imbalances pose another challenge. Although the current account deficit has narrowed significantly in recent years, to below 4% of GDP, a persistent current account deficit and a sizable net external liability position of almost 130% of GDP, together with reliance on external borrowing, leaves the country exposed to external shocks.
The small and relatively undiversified economy is also expected to remain heavily dependent on external demand for the foreseeable future. Competition from other Mediterranean locations may dampen growth in the sector and additional shocks from Europe could also have negative effects. If growth in tourism and business registrations slows significantly, growth prospects could be affected, as the domestic deleveraging continues.