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Rating action

Scope Ratings GmbH has today affirmed the Republic of Cyprus’s (Cyprus) BBB- long-term issuer and senior unsecured local- and foreign-currency ratings, along with its short-term issuer rating of S-2 in both local and foreign currency. All Outlooks remain Stable.

Summary and Outlook

Scope’s affirmation of Cyprus’s BBB- ratings reflects the country’s: i) strong growth potential, supported by good macroeconomic adjustment policies, long-term improvements in labour market conditions as well foreign-financed investment growth in important sectors; ii) solid fiscal consolidation prospects in view of Cyprus’s good record of fiscal consolidation, renewed commitment to fiscal discipline and strong growth outlook; and iii) sound structural reform momentum underpinned by a stable, reformist government and the EU-sponsored recovery plan. The rating is constrained by: i) a small, externally dependent and concentrated economy; ii) lingering though reducing vulnerabilities in the banking sector; and iii) high public and private debt levels combined with large external imbalances.

The Stable Outlook reflects Scope’s view that risks to the ratings are balanced over the next 12 to 18 months.

The rating/Outlook could be upgraded if, individually or collectively: i) there is continued strengthening of the banking sector; ii) post-crisis fiscal performance improves in line with expectations, placing public debt on a firm downward trajectory; and/or iii) the economy‘s growth potential is raised sustainably, for instance, through the development of new high-value added sectors.

Conversely, the rating/Outlook could be downgraded, if individually or collectively: i) medium-term growth prospects deteriorate substantially; ii) fiscal outcomes are weaker than anticipated, for instance due to a relaxation of fiscal discipline; and/or iii) banking sector fragilities re-emerge which weaken the country’s growth outlook and/or lead to additional liabilities for the government.

Rating rationale

The first driver of Scope’s affirmation of Cyprus’s BBB- ratings is the country’s strong growth potential. In the five years preceding the Covid-19 crisis, the Cypriot economy grew by 4.6% on average, one of the strongest growth rates in the euro area after Ireland (10%) and Malta (7.2%). Strong economic recovery following the 2012-13 domestic financial crisis has been underpinned by the government’s sound macro-economic adjustment policies. In addition, domestic demand rose due to improving labour market conditions as the unemployment rate and income inequality were on a steadily declining path, supporting private consumption. Rapid expansion in important sectors such as tourism, construction, real estate and financial and business services thanks to growing foreign investment also played a crucial role.

The Covid-19 crisis interrupted this positive trajectory as Cyprus’s GDP shrank by 5.2% 2020. The contraction in economic activity was relatively mild in view of its externally dependent economy, with a high reliance on tourism-related activities and customer-facing services, as well as the government’s stringent containment measures. The government’s effective and targeted measures to contain the spread of the virus, bolster the national health system as well as support firms and households was critical in mitigating the adverse economic effects of the crisis. Labour markets have been affected but large-scale job losses have been avoided so far. Unemployment peaked at 9% in September 2020 but has since dropped to 6.6% in October 2021, below pre-crisis levels. Similarly, employment exceeded 2019 levels in Q3 2021.

The economy rebounded strongly following the relaxation of containment measures. Scope expects it to reach its pre-crisis levels as early as Q4 2021 and real growth to reach 5.1% in 2021. Scope projects a strong economic recovery over the medium-term with 3.4% growth on average over 2021-26, reflecting the country’s strong growth potential of around 2.6%. Growth will be supported by continued rollout of the vaccine, a normalisation of consumption and investment activity, the implementation of the government’s EUR 1.2bn (5.3% of GDP) Recovery and Resilience Plan, and gradual recovery in the tourism sector. Important downside risks remain however including the persistence of the pandemic and its associated impact on external demand and international travel.

The second driver of the rating affirmation is Cyprus’s solid consolidation prospects. The country has a good record of fiscal consolidation thanks to fiscal discipline on spending and strong economic performance. Prior to the Covid-19 crisis, Cyprus was posting large primary surpluses - except in 2018 when a one-off transfer to support the financial sector was required - that averaged 2.7% of GDP over 2015-19. This had placed its public debt on a firm downward trajectory and granted the country substantial fiscal buffers to face the pandemic.

The countercyclical fiscal policies of the government in response to the Covid-19 crisis, while appropriate, have led to a substantial deterioration in the country’s near-term fiscal fundamentals. The budget deficit reached 5.7% of GDP in 2020 compared to a surplus of 2.5% of GDP in 2019. The fiscal stance has remained supportive near-term with extension of support measures in 2021 amounting to around 4.1% of GDP. As a result, the budget balance is expected to improve slightly but remain at a deficit of 5.1% of GDP in 2021. Thereafter, Scope expects a rapid improvement in fiscal metrics with a return to budget surpluses by 2024. This, coupled with strong growth and the government’s decision to reduce its large cash buffer (15% of GDP) will lead to substantial reductions in the debt-to-GDP ratio. Scope forecasts public debt to return to pre-pandemic levels by 2024 and reach 82% of GDP by 2026 from 107% of GDP in September 2021.

The benefits of strengthening medium-term fiscal performance for debt sustainability are also reinforced by improvements in Cyprus’s public debt profile thanks the country’s pro-active debt management strategy¹ . The Public Debt Management Office has made notable progress in lengthening the average maturity of marketable debt from 4.9 years in 2016 to 7.7 years in September 2021 with a low share of short-term debt (1%). Similarly, it has reduced exposure to interest rate and foreign currency risk. The share of floating rate debt (mostly made of up ESM loans) has decreased from 46% in 2016 to 29% in September 2021 while all debt is in domestic currency. Cyprus continues to benefit from very favourable financing conditions with its 10-year government bond yield at around 0.7% at year-end 2021, supporting a steady decline in the weighted average cost of debt from 4.2% in 2012 to 1.7% in September 2021.

The final driver of the affirmation at BBB- is the country’s sound structural reform momentum. Since the 2012-13 crisis and supported by the associated macro-economic adjustment programmes, the Cypriot State has achieved substantial progress in implementing a wide range of much-needed reforms to address its structural weaknesses. Public financial management and budgetary frameworks were strengthened via the implementation of the Financial Responsibility and Budget Framework Law, which has enhanced the transparency and sustainability of the public finances. Similarly, the government has introduced a comprehensive package of measures to strengthen supervision and reduce non-performing exposures in the banking sector. Other major reforms include changes to the pension system, judicial reform and the introduction of the National Health System.

Maintaining reform momentum is critical to address remaining structural challenges that could thwart the government’s economic recovery and fiscal consolidation efforts. Continued progress in enhancing the judicial system, strengthening financial oversight and improving local government administration would support institutional quality. Structural reforms that support greater diversification across sectors, foster growth in high value-added activities and green the economy are needed to sustainably enhance potential growth and economic resilience. A stable and reform-oriented political environment, the government’s renewed commitment to structural reform and the momentum provided by the EU-sponsored Recovery and Resilience Plan underpin Scope’s optimism on policymaking prospects.

Despite these credit strengths, Cyprus’s BBB- rating remains constrained by several factors.

First, the economy remains concentrated around a few externally dependent sectors such as financial and business services, tourism-linked activities as well as construction and real estate sectors, which have been the main growth drivers in recent years. These sectors are heavily reliant either on external demand or foreign funding. Vulnerability to external shocks such as the Covid-19 shock is very high given that nearly two thirds of real GVA and employment are tied to these sectors. The materialisation of an adverse scenario whereby the global economic outlook deteriorates substantially, and external demand drops could leave Cyprus more exposed than peer countries. Successful implementation of reforms under the Recovery and Resilience Plan and the Growth Strategy is thus critical to allow for reallocation of resources to other promising high value-added sectors.

Second, substantial banking sector vulnerabilities remain an economic and fiscal challenge. The stock of non-performing exposures (NPEs) on bank balance sheets remains very high, at EUR 5bn in July 2021. This in turn weighs on the domestic banking sector’s performance and profitability which remains a major challenge further exacerbated by the Covid-19 crisis. The sector posted a net loss in 2020 and has since recovered slightly and returned to profit in 2021 though with slim margins. Poor asset quality weighs on Cyprus’s growth potential by constraining the flow of credit while posing a risk to the sovereign balance sheet through explicit and implicit contingent liabilities. The country has made important strides in introducing the necessary frameworks to reduce the NPE stock. The NPE ratio has continued to decline despite the turmoil caused by the Covid-19 crisis, thanks to portfolio sales and write-offs reached 17% in July 2021, down from 28% at the start of 2020. At the same time, the pace of improvement has slowed and is contingent on the execution of large NPE transactions while a deterioration in credit quality due to the Covid-19 crisis still poses risks of reversal in recent gains.

Third, still high levels of public, private and external debt constrain the BBB- ratings. Household debt, at 91% of GDP in 2020, is the fourth highest in the EU after Denmark, the Netherlands and Sweden. Nonfinancial corporate debt levels, although declining, remain very high at 261% of GDP, well above the EU average (140% of GDP). In addition to this, Cyprus’s external position continues to be characterised by large imbalances. Sustained current account deficits have resulted in a net international investment position of -132% of GDP while external debt stands at 854% of GDP in Q3 2021. External imbalances are somewhat overstated due to the prevalence of special purpose entities that have a limited link to the real economy though the external position remains an important source of risk nonetheless. The IMF has assessed that the external position – adjusted for SPEs and temporary tourism and oil effects – is weaker than the level implied by medium-term fundamentals and desirable policies² . These elements, combined with an already high public debt, increase the economy’s sensitivities to shocks and can lead to mutually reinforcing negative feedback loops in a highly stressed scenario.

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 credit rating of ‘bbb’ as regards Cyprus. The ‘bbb’ indicative rating is further supported by the methodology’s reserve currency adjustment which provides a one notch uplift to the CVS indicative. The ‘bbb+’ indicative ratings can thereafter be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses against a peer group of countries.

For Cyprus, the following relative credit strengths via the QS have been identified: i) growth potential; and ii) fiscal policy framework. Conversely, the following relative credit weaknesses have been identified: i) macro-economic stability and sustainability; ii) current account resilience; external debt structure; iv) banking sector performance; v) financial imbalances; vi) environmental risks; and v) institutional and political risks.

Combined relative credit strengths and weaknesses identified in the QS generate a two-notch downward adjustment to the ratings and indicate a sovereign credit rating of BBB- for Cyprus.

A rating committee has discussed and confirmed these results.

Factoring of environment, social and governance (ESG)

Scope explicitly factors in ESG sustainability issues during its rating process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 20% weighting under the quantitative model (CVS) as well as in the methodology’s qualitative overlay (QS).

Under governance-related factors captured in Scope’s Core Variable Scorecard (quantitative model), Cyprus holds moderately strong scores on a composite index of six World Bank Worldwide Governance Indicators. Furthermore, Scope’s Qualitative Scorecard evaluation on ‘institutional and political risks’ indicates Cyprus as weaker than ‘bbb+’ indicative sovereign peers. Cyprus benefits from stable political conditions. The president, Níkos Anastasiádis, was re-elected in 2018 for another 5-year term with continued minority control over parliament following legislative elections in 2021. However, geopolitical risks remain on the island, with a division of the country between Greek and Turkish speaking communities. Negotiations over reunification of the country have stalled since talks broke down in April 2021. Tensions between Cyprus, Greece, the EU and Turkey over competing claims to hydrocarbon reserves persist and have intensified.

As regards social-risk factors, the quantitative model score is constrained somewhat by an ageing society in an international context, reflecting an increasing old-age dependency ratio over the long-term, although from a lower level than many peer economies. Income inequality – as captured by the ratio of the income share of the 20% of persons with the highest household incomes to the 20% of persons in society with the lowest household incomes – is low under an international comparison and compares favourably to Cyprus’s peer group. In addition, labour force participation of around 75% of the active labour force (aged 15-64) is above the peer group average. Under the QS, our assessment of ‘social risks’ is ‘neutral’. This reflects favourable and improving poverty and income inequality relative to peers thanks to effective economic and social policies. However, Cyprus performs relatively poorly as regards youth employment dynamics, gender equality and education outcomes, with its PISA scores ranking consistently among the lowest EU performers despite spending more on education.

Finally, on the sovereign ESG pillar’s environmental risk sub-category, Cyprus’s performance is comparatively weaker as regards the quantitative scoring. This reflects the carbon intensity of Cyprus’s economy, which is among the worst in the EU as measured by CO² emissions per euro. In addition, the physical constraints of its position as a small island state with limited natural resources lead to large deficits of the footprint of consumption relative to available biocapacity. At the same time, Cyprus is particularly vulnerable to the physical risks attached to climate change given rising risk of droughts, water scarcity and extreme temperatures, due to its position as a small Mediterranean island. Emissions reduction has lagged that of other EU states with a 4.1% decrease since 2005, below the EU-wide reduction of 19% over the same period also due to a rapidly expanding economy and population. Despite the country’s vast supply of renewable sources of energy, including solar, investment in this area is lagging and the economy still heavily relies on fossil fuels, which represented 90% of its total energy supply in 2019 according to the International Energy Agency. The country’s National Energy and Climate plan sets emission reduction targets of 21% compared to 2005, in line with the 24% target under the Effort Sharing Regulation when available flexibilities are taken into account. Plans to reduce emissions include a long-term strategy for building renovation, projects aimed at developing a natural gas system, the rollout of a renewable energy roadmap, investments to encourage a shift towards green mobility and the introduction of a carbon tax.

Rating Committee
The main points discussed by the rating committee were: i) severity of Covid-19 shock; ii) economic developments and outlook; iii) fiscal performance and outlook; iv) debt management strategy; v) financial system resilience and policies; and vi) geopolitical risks.

Rating driver references
1. Public Debt Management Office (2021)
2. International Monetary Fund (2021)

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sovereign Ratings’ 8 October 2021), is available on https://www.scoperatings.com/#!methodology/list.
Scope Ratings GmbH and Scope Ratings UK Limited apply the same methodologies/models and key rating assumptions for their credit rating services, while Scope Hamburg GmbH’s methodologies/models and key rating assumptions are different from those of Scope Ratings GmbH and Scope Ratings UK Limited.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With Rated Entity or Related Third Party Participation   NO
With Access to Internal Documents                                NO
With Access to Management                                          NO
The following substantially material sources of information were used to prepare the Credit Ratings: public domain.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Thibault Vasse, Senior Analyst
Person responsible for approval of the Credit Ratings: Dr. Giacomo Barisone, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 19 October 2018. The Credit Ratings/Outlooks were last updated on 23 August 2019.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
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