Fitch Ratings has affirmed Cyprus’s Long-term foreign and local currency Issuer Default Ratings (IDRs) at ‘B+’. The Outlooks are Positive. The issue ratings on Cyprus’s senior unsecured foreign and local currency bonds have also been affirmed at ‘B+’. The Country Ceiling is affirmed at ‘BB+’ and the Short-term foreign currency IDR at ‘B’.
RATING DRIVERS (Summary)
Cyprus is undergoing a major financial sector, fiscal, and economic adjustment following the 2013 banking sector crisis and the ensuing EU/IMF bail-out programme. The country’s early exit from the macroeconomic adjustment programme in March 2016 reflects a track record of fiscal consolidation, progress in financial sector restructuring and economic recovery.
A number of factors, however, continue to weigh heavily on Cyprus’s credit profile. At close to 109% of GDP in 2015, gross general government debt (GGGD) is more than twice the ‘B’ median, reducing Cyprus’s fiscal scope to absorb domestic or external shocks. With assets at 4x GDP, the banking sector’s exceptionally weak asset quality undermines economic stability and growth. The country’s weak external position implies that further economic rebalancing may be in prospect over the medium term.
Economic recovery is underway. GDP grew 1.6% in 2015, following three years of contraction resulting in a cumulative 11% loss of output until end-2014. Fitch projects GDP growth of around 2% per year for 2016-17, supported by household consumption benefiting from a decline in unemployment, and a pickup in tourism and investment.
Banks remain fundamentally weak and pose an ongoing risk to the economy and public finances. The ratio of consolidated sector NPEs (non-performing exposures) to total loans stood at 45% in December 2015, one of the highest of Fitch-rated sovereigns, though down from a peak of over 50% in 2014. Unreserved problem loans, represented by gross NPEs minus system-wide reserves, stood at EUR16.9bn (97% of GDP) at end-2015, compared with total bank capital of EUR6.6bn.
Major steps have been taken to restructure the banking sector. The new regulatory framework put in place since 2015 has enhanced the restructuring toolkit and contributed to a rise in restructurings, albeit from a low level. However, some 30% of restructured loans since January 2014 were in arrears (including of short duration) by end-2015. Progress is ongoing in bank supervision, both through the central bank and the EU Single Resolution Board, in full effect from January 2016.
The economic recovery is also translating into improved sector capitalisation and liquidity. In a sign of increased confidence, the central bank has reduced its dependence on emergency liquidity assistance, to EUR3.4bn in February 2016 from over EUR11bn in 2013. Deposits have been broadly stable since capital flow restrictions were lifted in April 2015.
Fiscal policy management has been strong, with the government continuing to over-achieve fiscal targets. Cyprus delivered a general government deficit of 0.5% of GDP for 2015, after a deficit of 0.2% in 2014. Fitch projects budget surpluses of 0.2% and 1% of GDP for 2016 and 2017, respectively, reflecting a neutral fiscal stance that is supported by the economic recovery. GGGD peaked at 108.9% of GDP in 2015, and is projected by Fitch to decline to below 100% by 2017. Debt-management operations and cash buffers, which at around 5.5% of GDP fully cover 2016 financing needs, reduce refinancing risks.
At 128% of GDP in 2015, Cyprus’s net external debt (NXD) is the third-highest of Fitch-rated sovereigns, reflecting a highly indebted private sector and the capital-intensive nature of the shipping industry. The current account position improved in 2015, albeit still a deficit of 3.6% of GDP in 2015.
Progress has been made with structural reforms, including selling the Limassol port and Casino. However, a number of bills are currently awaiting discussion in parliament following the May elections. The improved economy and exit from the adjustment programme could reduce the urgency for reform.
Negotiations for a reunification deal between Greek and Turkish Cypriots are underway. The likelihood of success and the terms of a potential deal remain uncertain. A deal would benefit both sides in the long term by boosting the Cypriot economy, giving the Greek side access to Turkey, and the Turkish side greater access to the rest of the world, but would likely entail short-term cost and uncertainties.
RATING SENSITIVITIES (Summary)
Future developments that may, individually or collectively, lead to an upgrade include:
- Further signs of a stabilisation in the banking sector, including a pick-up in loan restructurings
- Further track record of economic recovery and reduction in private sector indebtedness
- Continued fiscal adjustment leading to a decline in the government debt-to-GDP ratio
- Narrowing of the current account deficit and reduction in external indebtedness
- A sustained track record of market access at affordable rates
Future developments that may, individually or collectively, lead to a negative rating action:
- Re-intensification of the banking crisis in Cyprus
- A reversal of fiscal discipline, resulting in a less favourable trajectory in debt-to-GDP
- A return to recession or deflation with adverse consequences for public debt
- A lack of market access, putting pressure on government and banking system liquidity.
In its debt sensitivity analysis, Fitch assumes a primary surplus averaging around 2% of GDP, trend real GDP growth averaging 1.9%, an average effective interest rate of 3.6% and GDP deflator inflation of 1.3%. On the basis of these assumptions, the debt-to-GDP ratio would fall steadily to around 85% by 2025.
Debt-reducing operations such as privatisation (EUR1.4bn by 2018) are not incorporated in Fitch debt dynamics. Our projections also do not include the impact on GDP growth of potential gas reserves off the southern shores of Cyprus.
According to ECB rules, which exclude speculative-grade rated borrowers from the ECB scheme unless a bailout-related waiver is in place, Cyprus is no longer eligible for QE support. Fitch assumes that Cyprus will not need QE support to tap markets, although that could be more challenging in the event of shocks or less favourable market conditions.
Fitch’s base case is for Greece to remain a member of the eurozone, though it recognises that a resurfacing of ‘Grexit’ fears is a risk. Cyprus is exposed to Greece mainly via confidence effects, as its financial ties have been reduced significantly. Banks no longer hold Greek government bonds and are no longer exposed to the Greek private sector. The subsidiaries of the big four Greek banks in Cyprus have also been ring-fenced.
Source: Fitch Ratings (London, 22 April 2016)