Scope assigns Cyprus first-time credit rating of BBB- with Stable Outlook
Scope Ratings GmbH has today assigned the Republic of Cyprus a first-time BBB- long-term issuer and senior unsecured local- and foreign-currency ratings, along with a short-term issuer rating of S-2 in both local and foreign currency. All Outlooks are Stable.
Scope’s assignment of the BBB- rating for the Republic of Cyprus reflects the country’s euro area membership and subsequent access to a conditional lender of last resort (the European Stability Mechanism); the ongoing economic recovery and restructuring of the banking sector; fiscal outperformance, and moderate refinancing needs. However, the still-too-high stock of non-performing loans remains a key credit weakness given i) its impact on the fragile banking sector, constraining profitability and credit lending; and ii) the risk it poses to government finances in the context of a high public debt burden and a still-fragile market access. In addition, as a small economy serving as a regional financial hub and business centre, Cyprus has elevated external liabilities, partly driven by the activities of Special Purpose Entities (SPEs), and is also vulnerable to international initiatives on corporate taxation and/or the retrenchment of cross-border financial intermediation by foreign banks. The Stable Outlook reflects Scope’s assessment that the risks Cyprus is facing are broadly balanced.
Following the exit from its EU-IMF economic adjustment programme in March 2016, Cyprus’ economy has grown robustly, averaging 4.4% since Q2 2016, driven by solid private consumption, mostly foreign-funded investment (which has almost regained its pre-crisis level, at around 21% of GDP, in line with the euro area), tourism and related construction, business services, and retail trade. These positive developments are underpinned by the country’s prudent macro-economic and financial policies and progress on structural reforms, leading to gains in price competitiveness over recent years, with real unit labour costs 10% below their 2010 levels, in line with Portugal’s figure and below the relative developments in the euro area. Going forward, Scope expects real GDP growth to average around 3.8% during 2018-20, driven by foreign-funded investment and robust domestic demand, thanks to a continuously improving labour market, relatively low inflation and weak payment discipline, boosting real household disposable incomes. However, once the foreign-funded investments are completed, Cyprus’ economic growth is expected to moderate to around 2%-2.5%. While this growth potential remains above that of Portugal (1.2%) and the euro area average (1.7%), it also reflects Cyprus’ already moderately high per capita income, around 80% of the euro area average, which limits the scope for faster convergence-driven growth. In addition, Scope notes that the country’s growth potential remains constrained by high private sector leverage (around 300% of GDP as of Q1 2018) and non-performing loans (in June 2018 the NPL ratio stood at 38.9%), keeping financial sector vulnerabilities, and their potential consequences for the sovereign, elevated.
Scope also notes positively that Cyprus’ budget balance turned positive in 2016 – a significant turnaround from a deficit of around 9% of GDP in 2014 – which led to the country’s exit from the EU’s excessive deficit procedure in June 2016. Since then, fiscal performance has been very strong, with the general government balance recording a surplus of 1.8% of GDP in 2017, while the primary surplus increased to 4.3% of GDP from 3.1% of GDP in 2016. Despite these efforts, the sale of Cyprus Cooperative Bank (CCB), the second largest bank in the country, to Hellenic Bank resulted in a capital injection by the government of around EUR 3.5bn, which is expected to increase the debt-to-GDP ratio to around 110% in 2018, from around 97% in 2017.
Still, going forward, Scope expects a primary surplus of around 4% of GDP for 2018-20, slightly below the government’s 2018 Stability Programme but among the highest in the EU. This will be driven on the one hand by solid revenues due to the strong economic recovery and ongoing labour market improvements and, on the other, by expenditures increasing at a comparatively slower pace. Given Cyprus’ high debt level, expected primary surpluses going forward, and more moderate growth rates, Scope’s baseline scenario is for the debt-to-GDP ratio to decline from around 110% to around 80% by 2023. Despite this projected decline, debt-to-GDP will remain elevated, just below the IMF’s debt burden benchmark for advanced economies (85%) but above the Maastricht criterion (60%), indicating the need to maintain relatively high growth rates and a significant level of fiscal consolidation over multiple years. In addition, these projections exclude the risk from further banking-sector related contingent liabilities materialising on the government’s balance sheet.
Finally, the BBB- rating is also supported by Cyprus’ active debt management operations, with its funding policy ensuring liquid assets coverage of the following nine-month period and new issuance in euro and fixed-rate format only. This prudent approach also compensates for Cyprus’ small, illiquid and comparatively volatile bond market. While the CCB transaction will increase debt amortisation during 2019-21 from around EUR 1.4bn (7% of GDP) to around EUR 2bn (10% of GDP), refinancing needs are moderate over the medium-term. However, the low average maturity of outstanding debt securities – around 3.7 years, compared to Portugal’s figure (6) or the euro area average (7) – exposes the sovereign to funding shocks. Still, Scope notes that Cyprus benefits from its euro area membership as the sovereign can access – on a conditional basis – the ESM facilities, limiting market access vulnerabilities.
At the same time, Scope notes that several credit challenges constrain the rating. First, even after the CCB transaction, the banking sector remains fragile due to its large, albeit declining, stock of non-performing loans, which weighs heavily on the profitability and overall soundness of the banking system. Successive losses in the sector have led to a decline in the Common Equity Tier 1 capital ratio of all banks to 15.4% in Q2 2018 from 16.5% in Q4 2016. On the other hand, non-performing loans are likely to reduce by 50% by year-end, due to the removal of around EUR 6bn of CCB’s non-performing exposures as part of the transaction, and the sale of around EUR 2.7bn of non-performing exposures by the Bank of Cyprus to Apollo Fund. In addition, Scope notes that deposits have increased by EUR 5.4bn since the country’s exit from the EU-IMF programme, driven mostly by domestic residents. Still, while the restructuring of the banking sector has improved its overall soundness and is thus expected to contribute to the flow of credit in the economy, strengthening investor confidence, it also reinforces the link between the financial sector and the sovereign, raising the need for countercyclical bank capital buffers to reduce the probability and magnitude of shocks originating in the financial sector as well as strong fiscal buffers to absorb eventual crises.
Second, as a small economy with a large tourism industry and serving as a reginal financial hub and business centre, Cyprus consistently runs a large services-trade surplus (around 21% of GDP in Q2 2018) and a goods-trade deficit (around 22% of GDP in Q2 2018). As a result of successive current account deficits, Cyprus’ negative net international investment position (IIP) is substantial at around 111% of GDP as of Q2 2018. However, this reflects a marked improvement compared to the net IIP deficit of around 150% in Q4 2014. In addition, when excluding net liabilities of special purpose entities of around 75% of GDP, Cyprus’ net IIP is significantly lower at around -36% of GDP as of Q2 2018. Still, Cyprus’ role as a financial centre results in very high external debt, at around 500% of GDP in Q2 2018, down since Q2 2010 (837%) but still significantly above that of peers such as Portugal (208%) or Spain (168%). However, Scope notes positively that while gross financial flows are considerable relative to net positions and Cyprus’ GDP (stocks of IIP assets and liabilities respectively stand at 13x and 14x GDP as of Q2 2018), these are associated with special purpose entities (mostly financial), reflecting the country’s competitive advantage as a business and financial services hub, relate mainly to foreign direct investment (about 70% of total assets and liabilities), and are largely offsetting. Still, as a result, Cyprus is vulnerable to international initiatives on corporate taxation and/or the retrenchment of cross-border financial intermediation by foreign banks.
Finally, while the re-election of Nicos Anastasiades as president ensures a continued focus on fiscal consolidation, attracting foreign investments, and addressing the high NPL levels, the division of Cyprus – between the mainly Greek-speaking south and the mainly Turkish-speaking north for over four decades – remains a key geopolitical issue, as was again highlighted with Turkey's intervention in the Eastern Mediterranean and the Aegean Sea, blocking exploratory drillings by energy company Eni on Greek-Cypriot territory.
Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)
Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides an indicative ‘BBB’ (‘bbb’) rating range for the Republic of Cyprus. Scope affirms the indicative rating of ‘bbb’ for the Republic of Cyprus. This indicative rating range can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis.
For the Republic of Cyprus, the following relative credit strength has been identified: i) resilience of current account. Relative credit weaknesses are: i) macro-economic stability and sustainability; ii) debt sustainability; iii) market access and funding sources; iv) external debt sustainability; v) vulnerabilities to short-term external shocks; vi) geopolitical risk; vii) banking sector performance; and viii) financial imbalances and financial fragility. The combined relative credit strengths and weaknesses generate a one-notch negative adjustment and indicate a sovereign rating of BBB- for the Republic of Cyprus. A rating committee has discussed and confirmed these results.
For further details, please see Appendix II of the rating report.
Factoring of Environment, Social and Governance (ESG)
Scope considers ESG sustainability issues during the rating process as reflected in its sovereign methodology. Governance-related factors are explicitly captured in Scope’s assessment of ‘Institutional and Political Risk’, for which Cyprus scores moderately according to the World Bank’s Worldwide Governance Indicators. Qualitative governance-related assessments in Scope’s ‘recent events and policy decisions’ and ‘geo-political risk’ categories of its QS are assessed as ‘neutral’ and ‘weak’ compared with Cyprus’ sovereign peers. Socially related factors are captured in Scope’s CVS in Cyprus’ moderate GDP per capita (USD 25,380 in 2017) and falling level of unemployment, but moderately high old-age dependency ratio. Qualitative assessments of social factors are reflected in Scope’s ‘macroeconomic stability and sustainability’, for which Scope assesses Cyprus as ‘weak’. Finally, environmental factors are considered during the rating process but did not have an impact on this rating action.
Outlook and rating-change drivers
The Stable Outlook reflects Scope’s assessment that the risks faced by Cyprus remain balanced at this stage. The rating could be upgraded if: i) the banking sector is further strengthened; ii) the public debt stock is reduced in a sustained manner; and/or iii) the government negotiates a sustainable solution to its geopolitical risks (reunification of the island).
Conversely, the rating could be downgraded if: i) public finances deteriorate due to a reversal of fiscal consolidation; ii) there is a fading commitment to or a reversal of structural reforms, including judiciary reform, leading to an adverse impact on the medium-term economic and fiscal outlook; and/or iii) banking sector fragilities re-emerge in the form of additional liabilities to the government.
The main points discussed were: i) Cyprus’ growth potential; ii) macroeconomic stability and sustainability; iii) fiscal consolidation, contingent liabilities, public debt sustainability, debt structure and market access; iv) external debt sustainability and vulnerabilities, including through special purpose entities; v) banking sector challenges; vi) political developments; and vii) peers.
The methodology applicable for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available on www.scoperatings.com. Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default as well as definitions of rating notations can be found in Scope’s public credit rating methodologies on www.scoperatings.com. The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months.
Solicitation, key sources and quality of information
The rating was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the rating process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party. The following substantially material sources of information were used to prepare the credit rating: public domain and third parties. Key sources of information for the rating include: Central Bank of Cyprus, Ministry of Finance, Eurostat, BIS, IMF, ECB, OECD, WB, and Haver Analytics.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Prior to the issuance of the rating or outlook action, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Rating prepared by Alvise Lennkh, Director.
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director
The ratings/outlook were first released by Scope on 19.10.2018.
As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on the Republic of Cyprus are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see "Sovereign Ratings Calendar of 2018" published on 21 September 2018 on www.scoperatings.com. Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation. In this case the deviation from Scope’s published calendar was due to the first-time release of the ratings.
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.
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