DBRS confirms Republic of Cyprus at B, trend changed to ‘positive’
DBRS Ratings Limited (DBRS) has confirmed the Republic of Cyprus’s longterm foreign and local currency issuer ratings at B and changed the trend to Positive from Stable. DBRS has also confirmed the short-term foreign and local currency issuer ratings at R-4 and maintained the Stable trend.
The ratings reflect Cyprus’s solid fiscal performance achieved under the economic adjustment programme, as well as its attractiveness as a business services centre and a tourist destination, Eurozone membership, which has ensured financial support, and its favourable public debt maturity profile. However, the ratings also underline the depth of Cyprus’s challenges, given its high levels of public and private sector debt, sizable non-performing loans, external imbalances and the small size of its service-driven economy.
The Positive trend reflects DBRS’s view that the fiscal adjustment is likely to be maintained, even if growth decelerates slightly. Fiscal reforms adopted during the economic adjustment programme should help support a sound budget position. The primary fiscal balance is expected to remain in surplus, which together with the ongoing economic recovery, is leading to the gradual reduction of the public debt ratio. The economic recovery remains partly dependent on external demand, but it is expected to continue at a steady pace. Improvements in the “Fiscal Management and Policy” and “Economic Structure and Performance” sections of our analysis were the key factors for the trend change.
Cyprus’s fiscal performance has been strong. The government achieved a quick adjustment in the budget position, with the headline deficit falling from 5.8% of GDP in 2012 to 1.1% in 2015 (including recapitalisation costs of cooperative banks equivalent to 1% of GDP) and the primary deficit shifting to a surplus of close to 2% of GDP. This surplus is expected to remain around these levels over the coming years. Fiscal management has been strengthened, through the adoption of reforms to the tax administration and other institutional reforms, which should help maintain the adjustment. The public debt maturity structure is also favourable and provides further support to the ratings. The average debt maturity is now close to eight years. The government has benefited from lower interest rates and extended debt maturities, thus reducing refinancing risks.
Strengthened institutions and policies, together with a favourable corporate tax environment, support the attractiveness of Cyprus as a business services centre. Although its advantage could be eroded by external competitors or regulatory changes, 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 as an attractive tourist destination. The tourism sector has shown resilience, adapting to new markets in recent years.
Cyprus benefits significantly from its membership in the Eurozone. Policy measures implemented by Cyprus since its EU accession in 2004 and adoption of the Euro in 2008, and more recently, under the three-year EU/IMF economic adjustment programme, have helped strengthen domestic institutions.
The programme, which concluded in March 2016, allowed Cyprus to consolidate its public finances and restructure its banking sector. EU budget transfers and long-term infrastructure financing from the European Investment Bank has also contributed to investment.
Nevertheless, Cyprus faces several credit challenges. General government debt is high at 107.5% of GDP. Although the debt ratio is estimated to have peaked and the fiscal adjustment appears complete at this stage, continued fiscal surpluses and sustained solid economic growth will be essential to bring debt down to more manageable levels.
Private sector debt ratios are also at historically high levels. This suggests that deleveraging could continue to weigh on investment and consumption. Household and corporate balance sheets were damaged in the crisis, through the bail-in of uninsured depositors and the fall in real estate prices. At the same time, banks’ non-performing loans are extremely high, at 48.2% of total loans, although important efforts are being taken to speed the resolution of NPLs. Restructured loans will continue to be classified as NPLs for at least 12 months after being restructured. Taking into account only the 90-days past due loans, the NPL ratio is 36.1%.
In addition, although the current account deficit has narrowed markedly in recent years, a deficit and a large net external liability position, leaves Cyprus reliant on external financing and exposed to shocks. These imbalances reflect in part the international business centre and shipping centre. Cyprus’s small, service-driven economy is also dependent on external demand. Although tourism benefits from a market of wealthy economies, a severe downturn in Europe and competition from other Mediterranean locations could dampen growth in the sector. If growth in tourism and business services slows significantly, GDP growth prospects could be affected.
Upward rating action will depend on Cyprus’s ability to sustain economic growth and primary fiscal surpluses over the medium term.
Continued recovery of the economy and sustainability of the fiscal adjustment should improve the outlook for public debt dynamics. A material reduction of nonperforming loans and stronger progress on the privatisation plan could also put further upward pressure on the ratings. However, a prolonged period of weak growth, particularly if combined with fiscal slippage and higher financing needs, could lead to a change in the trend back to Stable. Weaker growth and lower investment in tourism, financial services and the energy sector could result from external factors, including a downturn in the Eurozone. Such developments could result in downward pressure on the ratings.