Cyprus return to investment grade is well deserved, but no room for complacency
The Cyprus sovereign received an upgrade from S&P Global to investment grade recently, for the first time since January 2012 when first downgraded below that level.
For a little bit of history and perspective, Cyprus was downgraded a total of 12 notches from the middle of 2010 to the middle of 2013, and then received upgrades of seven notches in all, leaving a deficit of five notches for restoring the initial position.
It has been a long path through crisis and recession to recovery. While an investment grade is an i mportant achievement in its own right, not least because of the benefits it brings, but also for the psychological boost it means for the country and its people, it is not the end of the road. We should and do aspire for a much higher rating on the scale, which would mean the further streamlining of policies to specific targets and necessary reforms.
The upgrade to investment level by itself brings significant benefits. It means the country qualifies for the European Central Bank’s monetary policy operations and for its asset purchases in the context of its quantitative easing programme. Hence, pressures on the sovereign’s borrowing costs, long and short, will ease further and the corresponding interest rate spreads will likewise narrow more. This will be helping to reduce debt service costs and will also eventually support, though this might take some more time, lower borrowing costs for corporates in commercial debt markets.
Where does the upgrade to investment level come from? Well, it comes from the performance of the country and the economy from the depths of the crisis to economic adjustment, the restructuring that ensued and the recovery we see today.
A lot has
the government, the banks, and the regulatory infrastructure.
In the government sector there has been a significant adjustment. On a net basis, between 2012 and 2017, the budget adjustment has been in excess of 8% of GDP. This came through mostly as expenditure cuts.
Despite all the measures that were taken, revenue increases started to show more clearly in 2017 only, as the recession and declining nominal incomes curtailed such gains earlier. This means that as the economy continues to perform as anticipated and as modest inflation kicks in, the revenue side will be driving the budget surpluses in the medium term even as expenditures start to rise.
However, the structure of public spending poses problems as some functional areas remain heavily underfunded while others are absorbing disproportionate budget outlays.
A rationalisation will be needed through the political process which is a longer term issue.
Despite the significant increase of public debt as a result of the government injecting EUR 3.2 bln into the Cyprus Cooperative Bank to facilitate its resolution and the sale of its performing assets, the underlying debt dynamics remain favourable. Debt dynamics are aided by sustained and sizable primary budget surpluses in recent years, strong economic growth, and low interest rates.
Strong economic growth requires investments which in turn require a stable macroeconomic environment and ease of doing business. Economic performance and sound public finances add to the credibility of the government, which translates to easier access to bond markets at more favourable terms.
In the banking sector also, there has been considerable restructuring and improvement. Banks have downsized their balance sheets to a large extent, by refocusing their activities in their core markets, deleveraging on private sector indebtedness and by reducing their large non-performing exposures.
Between end-2012 and July-2018 gross loans outstanding dropped by 20% in the household sector and by 30% in the corporate sector. Dependence on emerging liquidity assistance has now been entirely eliminated and replaced by considerable excess liquidity, measured on the basis of net loans to deposits with net loans being gross loans less provisions. Non-performing exposures dropped from EUR 30 bln in April 2015 to about 20 bln in April 2018. The sale of the Cyprus Cooperative Bank in the summer entails the transfer of EUR 5.7 bln of gross non-performing exposures to the residual entity outside of the banking system.
At the same time, Bank of Cyprus’ sale of EUR 2.7 bln will also reduce gross non-performing exposures in the banking system. Total non-performing exposures will thus drop to EUR 11-12 bln by year end or 34% of total loans.
Furthermore, of the remaining non-performing exposures a significant part has been restructured and expected to become performing as the required conditions are met. The recently legislated ESTIA scheme will help vulnerable borrowers to restructure their mortgage loans and therefore accelerate the reduction of their non-performing exposures.
In terms of the regulatory infrastructure, the recent changes in legislation regarding foreclosures and insolvency will enable banks to reduce the strategic defaulters and thus reduce non-performing exposures faster.
Further reductions in non-performing exposures in the banking sector and also in the stock of public debt will be need over the next couple of years before additional upgrades will become possible. Whilst the country is allowed to celebrate the return to investment grade status, we cannot grow complacent. There is still a lot that remain to be done in order to reduce vulnerability and increase resilience. The author is Manager, Economic Research at Bank of Cyprus. The views expressed are personal and may not necessarily reflect those of the bank