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Scope Ratings GmbH has today affirmed the Republic of Cyprus’ 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.

Rating drivers

Scope’s affirmation of the Republic of Cyprus’ BBB- rating reflects the country’s continued economic recovery and fiscal consolidation as well as its euro area membership. However, a concentrated and externally-dependent economy presents risks to the stability and sustainability of Cyprus’ growth model, and subsequently its fiscal performance and financial stability. In addition, the still elevated stock of non-performing loans (NPLs) remains a key credit weakness given i) the resulting vulnerabilities in the banking sector, weighing on profitability and constraining credit supply; and ii) the risk it continues to pose to public finances in the context of a high public debt burden. Finally, high levels of public and private indebtedness combined with a vulnerable external position pose risks in the case of significant changes in market sentiment and a tightening of global financing conditions. The Stable Outlook reflects Scope’s assessment that the risks Cyprus faces are broadly balanced.

Cyprus’ economy has one of the strongest growth rates in the euro area. Real growth has averaged 4.2% YoY since the country’s exit from the EU-IMF economic adjustment programme in March 2016. Growth is supported by private demand, owing to improving labour market conditions as well as foreign-financed investment growth in construction, real estate, shipping and tourism-related sectors. These positive developments have also been underpinned by the country’s export competitiveness with real unit labour costs over 10% below pre-crisis levels. This is reflected in Cyprus’ share in world exports, which is at its highest point since 1996.

Going forward, Scope expects real GDP growth to average around 3% over 2019-21, supported by sustained foreign investment and robust domestic demand. Over the medium-run, growth is expected to moderate and converge towards the country’s potential of 2-2.5% as the pipeline of investments gradually tapers off and improved payment discipline reduces disposable income, as recently highlighted by the IMF. While Cyprus' growth potential remains above the IMF estimates for Spain (1.75%), Portugal (1.4%) and Italy (0.5%), this also reflects Cyprus’ moderate-to-high real GDP per capita - around 75% of the euro area average - which limits the scope for faster income-convergence-driven growth. In addition, Scope notes that the country’s growth potential remains constrained by i) a highly-leveraged private sector, which weighs on investment; ii) still elevated non-performing loans, which increase banks’ risk aversion and limit domestic credit supply; iii) lagging productivity growth, due to barriers to digital technology adoption, limited investment in productivity-enhancing areas and low R&D; and iv) shortcomings in the business environment, as highlighted by the European Commission. Additionally, any tension between Turkey and Cyprus remains a key geopolitical issue. Formal negotiations for unification of the island have been suspended since July 2017 and Scope does not expect the two parties to come to an agreement in the near-term.

Scope notes positively that Cyprus’ fiscal performance, net of the government’s support to the financial sector, remains robust with primary surpluses averaging 4.5% of GDP over the 2016-18 period. However, in 2018, the general government deficit deteriorated to 4.8% of GDP due to the government’s support in the sale of Cyprus Cooperative Bank to Hellenic Bank. The transaction increased the country’s debt-to-GDP ratio to 102.5% while public guarantees rose by over 10 percentage points to 22.6% in 2018, the second highest level among euro area member states. However, net of this one-off expenditure, the headline balance stood at a surplus of 3.5% of GDP, a significant improvement on a surplus of 1.8% of GDP in the previous year. The country’s budgetary performance thus reflects both the government’s prudent fiscal policy, which continues to be geared towards achieving high surpluses and supporting a gradual decline in the debt-to-GDP ratio, and downside risks due to remaining vulnerabilities in the banking sector.

On this basis, absent the materialisation of further contingent liabilities, Scope expects Cyprus’ fiscal performance to remain robust with a projected primary surplus of around 3-4% of GDP for 2019-20, slightly below the government’s 2019 Stability Programme targets, which is still the highest in the euro area. This is mainly supported by robust growth and the improving labour market, supporting tax revenue growth. Expenditure is also set to increase – albeit at a slower pace – due, in part, to increasing employee compensation and social payments linked to pension outlays. Overall, the IMF projects Cyprus’ debt to decrease to around 67% of GDP by 2024, while Scope’s baseline, based on slightly more conservative growth and primary balance estimates, projects a debt-to-GDP ratio of around 75% by 2024. This would nonetheless represent a significant improvement from the peak debt ratio of 108% in 2014-15.

Still, downside risks to the realisation of this debt trajectory include the government’s exposure to contingent liabilities related to the Cypriot banking sector and state-owned enterprises alongside fiscal costs from recent court rulings that crisis-era public sector wage and pension cuts are unconstitutional. The latter cases are currently in an appeal process with the potential fiscal impact unclear at this stage. Finally, the launch of the General Healthcare System in June 2019, which is designed to have a balanced budget over the long term, could come at a cost to the government as the State is required to finance any realised deficit of public healthcare providers through 2024.

The BBB- sovereign rating is also supported by Cyprus’ prudent debt management strategy, which aims to smoothen the debt redemption profile, increase the average debt maturity and reduce exposure to foreign-currency and interest-rate risk. In addition, Scope views positively the Public Debt Management Office’s funding policy, which ensures that liquid assets (at 14% of GDP in May 2019) cover financing needs for at least the next nine months. The average residual maturity of debt has increased from 4.2 years to 7.0 years by mid of 2019 partly due to the issuance of 15-year and 30-year bonds with yields of 2.76% and 2.84% respectively. These issuances – the country’s longest maturity eurobonds issued to date – reflect Cyprus’ improved borrowing conditions and market access under a very low global interest rate environment. In this context, Scope notes that Cyprus benefits from its euro area membership as the country recently gained access to the ECB’s public sector purchasing programme, which has pushed sovereign bond yields to historic lows. Cyprus can further, in case of need, make use of ESM facilities on a conditional basis.

Despite these credit strengths, Cyprus’ rating faces several constraints:

First, the economy remains concentrated around a few externally-dependent service sectors, specifically, financial and business services, tourism-linked activities as well as the construction and real estate sectors, which have been the main contributors to growth in recent years and are heavily reliant on external demand and foreign funding. These sectors, which, based on CYSTAT and central bank data, account for 53% of national GDP, 47% of employment and 33% of total loans outstanding, are very sensitive to regional and global developments. Therefore, a deterioration in the global economic outlook or international investor sentiment presents downside risks to the country’s growth outlook, and subsequently its public finances and financial stability. The government’s Action Plan for Growth focused on structural reforms could help diversify the economy by supporting nascent industries such as the ICT, education and health sectors. However, Scope notes that limited progress in key reform areas has been made so far, as also highlighted by the European Commission.

Second, vulnerabilities in the banking sector persist due to a large, albeit declining, stock of NPLs, posing a risk to the overall soundness of the Cypriot financial system and to the sovereign balance sheet through explicit and implicit contingent liabilities. While the successful removal of non-performing exposures owned by Cyprus Cooperative Bank and the Bank of Cyprus (which totalled EUR 8.4 bn) from the banking sector in 2018 contributed to a significant decrease in the NPL ratio, the latter remains one of the highest in the EU at 30.9% of outstanding loans as of Q1 2019 (EUR 10.3bn, or 49% of GDP). As a positive development, the banking sector has returned to profitability since the beginning of 2018, allowing banks to increase their capitalisation levels. The common equity tier 1 ratio reached 16% of risk-weighted assets in Q1 2019, up from 14% a year earlier.

In addition, a series of legal proposals adopted by the government in July 2018 to remove impediments to NPL resolution is a welcome development. These include: improvements to the legislative framework governing foreclosures and insolvency and new laws for the sale of loans and securitisation. While there remain some uncertainties regarding the foreclosure legislation, these measures, combined with the launch of the ESTIA burden-sharing scheme, should support further NPL reduction and contribute to reviving the flow of credit to the real economy.

Third, high levels of indebtedness in the public and private sector as well as large external imbalances constrain Cyprus’ ratings. As a small, open and service-oriented economy, Cyprus typically runs a large services trade surplus (19% of GDP in 2018) and a larger goods trade deficit (21% of GDP), resulting in overall large current account deficits (7% of GDP). Successive current account deficits have resulted in one of the weakest net international investment positions in the euro area, at -115% of GDP in 2018. Similarly, Cyprus’ short-term external debt, which represents a quarter of total external debt of 495% of GDP, is very high at 126% of GDP, although this has decreased notably from a 2010 peak of 454%, mostly due to deleveraging in the banking sector.

Scope notes that Cyprus’ external statistics are impacted by the prevalence of special purpose entities (SPEs), which have limited links to the real economy. Adjusted for the effects from SPEs, external imbalances are less pronounced, with the current account balance at -4.5% of GDP (instead of -7.0%), the net international investment position at -38% of GDP (instead of -115%) and gross external debt at 267% of GDP (instead of 495%). Nevertheless, imbalances remain elevated and result in high levels of external financing needs, leaving Cyprus exposed to changes in external economic conditions as highlighted in the Cypriot Economy and Competitiveness Council’s recent report.

Finally, Cyprus’ vulnerabilities are exacerbated by a highly-leveraged private sector, despite deleveraging in recent years. Non-financial corporate (excluding SPEs) debt has decreased from the 2015 peak of 152% of GDP to around 120% of GDP in Q1 2019 while household debt stood at 97% of GDP, well above the euro area average of 64%. The overall private sector debt overhang – with levels above that of the euro area average of 205% of GDP – combined with a high public debt burden reduce the country’s resilience to economic downturns and increase economic sensitivities to tightening global financial conditions. Scope expects the enhanced insolvency and foreclosure frameworks to contribute to further reductions in nominal private debt levels while strong growth is expected to facilitate a decrease in the economy-wide debt burden.

Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)

The rating committee reviewed Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals and assigned an indicative ‘BBB’ (‘bbb’) rating range 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 weaknesses have been identified: i) macro-economic stability and sustainability; ii) market access and funding sources; iii) external debt sustainability; v) vulnerabilities to short-term external shocks; vi) banking sector performance; vii) financial imbalances and financial fragility; and viii) geopolitical risks. No relative credit strengths have been identified. 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.

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’, on which Cyprus scores in the middle-range 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 28,340 in 2018) and falling levels of unemployment, but moderately high old-age dependency ratio. Qualitative assessments of social factors are reflected in Scope’s ‘macroeconomic stability and sustainability’ assessment, on which Scope evaluates Cyprus as ‘weak’.

Finally, environmental factors are considered during the rating process but did not have a material impact on this rating action. Scope notes that according to the European Commission, Cyprus is expected to miss greenhouse gas emissions targets in 2020 and 2030 by 12.5 and 47.4 percentage points respectively. Similarly, the country performs poorly in terms of environmental performance with waste generation significantly higher than the EU average and increasing since 2014 while energy efficiency in residential and commercial buildings is still lacking, based on European Commission assessments. While the National Energy and Climate Plan provides an extensive overview of Cyprus’ investment needs and details planned measures to reach national targets, the European Commission has recommended that the level of ambition regarding the country’s renewable energy and energy efficiency targets should be revised upwards while further clarity on measures Cyprus intends to implement to reach 2030 emissions target is warranted.

Outlook and rating-change drivers

The Stable Outlook reflects Scope’s assessment that the risks faced by Cyprus remain balanced at this stage. The ratings/Outlooks could be upgraded if: i) the banking sector is further strengthened; ii) the public debt stock is significantly reduced and/or iii) the growth potential of the economy is raised sustainably, for instance, through the development of new high-growth-potential sectors.

Conversely, the ratings/Outlooks 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 with regards to judiciary reform, leading to an adverse impact on the medium-term economic and fiscal outlooks; and/or iii) banking sector fragilities re-emerge in the form of additional liabilities to the government.

Rating committee
The main points discussed were: i) growth potential of the economy; ii) fiscal performance and outlook; iii) public debt sustainability and contingent liabilities; iv) banking sector vulnerabilities and NPL resolution framework; v) geopolitical risks and political developments.

Methodology
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 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, CYSTAT (Statistical Service of Cyprus), Ministry of Finance, Eurostat, IMF, ECB, European Commission, 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.

Regulatory disclosures
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 and last updated 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.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
© 2019 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions 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. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstrasse 5, D-10785 Berlin.
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