Scope affirms the Republic of Cyprus's credit ratings at BBB-; Outlook revised to Positive
For the updated rating report, click here.
Scope Ratings GmbH (Scope) has today affirmed the Republic of Cyprus’s (Cyprus) BBB- long-term issuer and senior unsecured local- and foreign-currency ratings and revised the Outlook from Stable to Positive. Scope has also affirmed Cyprus’s short-term issuer rating of S-2 with a Stable Outlook in both local and foreign currency.
Summary and Outlook
Scope’s decision to revise the Outlook from Stable to Positive reflects the country’s: i) solid growth prospects, supported by long-term improvements in labour market conditions, foreign-financed investment in important sectors as well as structural reform; ii) robust fiscal trajectory, underpinned by Cyprus’s good consolidation record, renewed commitment to fiscal discipline and strong growth outlook; and iii) continued strengthening of the banking sector through significant progress in reducing non-performing exposures. The rating is constrained by Cyprus’s: i) small and externally dependent economy; and iii) high public and private debt levels combined with large external imbalances.
The Positive Outlook reflects Scope’s view that risks to the ratings are tilted to the upside over the next 12 to 18 months.
The ratings 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, resulting in material reductions in public debt; and/or iii) the economy’s growth potential is raised sustainably, for instance, through the development of new high value-added sectors.
Conversely, the ratings/Outlooks 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 sovereign.
The first driver of the Outlook change to Positive is the country’s solid growth prospects. The Covid-19 crisis interrupted a remarkable trend of strong growth following the 2012-13 domestic financial with GDP shrinking by 5% in 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 stringent containment measures. The government responded forcefully to the crisis through effective and targeted measures to contain the spread of the virus, bolster the national health system as well as support firms and households. This was critical in mitigating the adverse economic effects of the crisis, avoiding large scale job losses and corporate bankruptcies, and limiting damage to its growth potential.
The economy rebounded strongly following the relaxation of containment measures. Real GDP reached its pre-crisis levels as early as Q3 2021 and grew by 5.5% in 2021, well above the government’s 2021-24 Stability Programme1 forecast of 3.6%, while unemployment has dropped to 5.4% in April 2022, the lowest level since 2009. The country is facing headwinds in the form of persisting Covid-19 infections and the economic knock-on effects of the war in Ukraine, including rising inflation and the associated tightening of monetary policies globally. Cyprus is reliant on trade with Russia as exports to the country represent 8.4% of GDP, mostly through tourism (Russia accounted for around 20% of tourism arrivals in 2019) and professional services. The short-term economic outlook for Cyprus has thus weakened somewhat but Scope expects the country to continue its robust recovery with 2% growth in 2022 followed by 2.7% on average over 2023-26.
Strong medium-term growth will be supported by a normalisation of private consumption and investment patterns, the recovery in external demand and the country’s strong growth potential estimated at 2.5%. Importantly, the government’s national Recovery and Resilience Plan (RRP) and associated investments and structural reforms will be critical for underpinning longer-term growth and addressing structural economic bottlenecks2. The RRP includes EUR 1.2bn (5.2% of 2021 GDP) in spending to be mobilised over the coming years. Investments and structural reforms under the RRP aimed at enhancing public and local administration, judicial capacities as well as education and skills of the domestic workforce will be key to supporting productivity growth while the plan’s focus on greening the economy will help make Cyprus’s growth model more sustainable. The RRP fits into the country’s EU-sponsored longer-term strategy, “Vision 2035”, aimed at transforming Cyprus’s growth model, diversifying its economy, and improving social outcomes. If implemented successfully, the IMF expects that the RRP will raise potential growth by 0.5pps within the next five years3 . The country’s solid record of structural reform implementation and EU fund absorption as well as its reform-oriented government underpins Scope’s confidence in Cyprus’s economic prospects despite lingering downside risks.
The second driver of the Outlook change relates to Cyprus’s robust fiscal trajectory that has placed debt on a firm downward trajectory. Cyprus’s fiscal fundamentals have recovered swiftly from the deterioration observed in 2020 on the back of the strong economic recovery. After posting a budget deficit of 5.8% of GDP due to large Covid-19 economic support measures, the budget deficit narrowed substantially in 2021 to 1.7% of GDP, well below the 2021-24 Stability Programme target of 4.7% of GDP4 . Cyprus’s budgetary performance outperformed expectations thanks to buoyant revenue growth, gradual withdrawal of Covid-19 support measures and lower than expected current spending.
The government’s medium-term budgetary strategy aims at maintaining fiscal support for the economy near-term, in line with the RRP, whilst maintaining fiscal sustainability and reducing public debt in a sustainable manner longer-term. Recently, the government announced a series of financial support measures totalling EUR 300m (1.2% of GDP) to offset the impact of the war in Ukraine and the associated inflationary pressures for households. As such, Scope’s baseline projections see the budget deficit remaining broadly unchanged at around 2% of GDP in 2022. Thereafter, the budget balance should improve steadily and reach a surplus of 1% of GDP by 2027. This view is underpinned by the government’s good record of fiscal discipline. 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.
Strong economic growth, improving budget balances and higher inflation has placed Cyprus’s public debt ratio on a firm declining path. After rising sharply to 115% of GDP in 2020, up from 91% the year before, the debt-to-GDP ratio declined to 104% in 2022. Scope expects Cyprus’s public debt to return to pre-pandemic levels by 2024 and reach 75% of GDP by 2027, one of the strongest reductions among EU countries. Importantly, Scope’s stressed scenario, which includes a combination of macro-fiscal and interest rate shocks, would still result in declining public debt, albeit at a more moderate pace. 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 strategy5 . 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 at year-end 2021 with a low share of short-term debt (1%). Similarly, it has reduced exposure to interest rate with 69% of total debt being fixed rate and no foreign currency exposures. Finally, the debt management strategy commits to maintaining a cash buffer sufficient to meet the country’s gross financing needs throughout the year, providing an important liquidity buffer. As of year-end 2021, the cash buffer stood at EUR 2.8bn (12% of GDP) and enough to comfortably cover the 2022 funding needs, estimated at EUR 2.1bn6 .
The final driver of the revision of the Outlook is Cyprus’s substantial progress in reducing banking sector vulnerabilities, mainly in the form of the non-performing exposures (NPEs) that have constituted a key credit challenge for the country since the 2012-13 domestic financial crisis. Elevated NPEs not only weigh on economic growth through impaired credit supply but also present a contingent fiscal risk to the sovereign. The government has enhanced the legislative framework for NPE management throughout the years including via improvements to the foreclosure framework, the creation of KEDIPES, a state-owned asset management company, or the introduction of ESTIA, a subsidy scheme for vulnerable borrowers. As a result of these efforts, the NPE ratio in Cyprus has declined substantially. Importantly, the NPE ratio continued to improve in the wake of the Covid-19 pandemic even after the withdrawal of emergency support measures despite early fears of a rapid deterioration in asset quality. The NPE ratio reached 11% in December 2021, down from 27% in March 2020 and from the 2014 peak of 49%.
In addition to improved asset quality, the Cypriot banking sector is better positioned to face shocks in view of stronger capitalisation and liquidity levels which remained at comfortable levels throughout the Covid-19 crisis. Banks’ capital positions remained strong with a tier 1 ratio of 18.9% in September 2021, broadly unchanged since year-end 2019 while the sector’s liquidity coverage ratio reached a comfortable 312% at year-end 2021, up from 298% at year-end 2019. As such, the sector has demonstrated its improved resilience throughout the crisis. Finally, the size of the banking sector relative to the Cypriot economy has declined substantially with total assets dropping from a 2012 peak of 632% of GDP to 280% of GDP in September 2020, more in line with the EU aggregate sector size (213% of GDP). With a stronger financial footing, more limited systemic importance, and an improved institutional capacity to manage with NPEs, the risks stemming from Cyprus’s banking sector to the sovereign have declined in recent years though they remain a key credit challenge.
Beyond banking sector vulnerabilities, Cyprus’s BBB- rating continues to be constrained by additional factors.
The economy remains reliant on a few externally-dependent sectors such as financial and business services, tourism-linked activities as well as the construction sector, 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 is high given that nearly two thirds of real GVA and employment are tied to these sectors, as the Covid-19 shock or the Ukraine crisis have illustrated more recently. 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 RRP and Vision 2035 is thus critical to allow for reallocation of resources to other promising high value-added sectors such as higher education, renewable energies, agri-tech or ICT solutions for instance.
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 in recent years, remain very high with financial liabilities standing at 169% of GDP, well above the EU average (71% 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 -123% of GDP while external debt stands at 822% of GDP at year-end 2021. External imbalances are somewhat overstated due to the prevalence of special purpose entities that have a limited link to the real economy but remain an important source of risk. The IMF has highlighted that Cyprus’s external sector remains exposed to liquidity and other risks given large external gross financing needs (over 150% of GDP). 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 ‘a-’ 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 weaknesses have been identified: i) macro-economic stability and sustainability; ii) current account resilience; iii) external debt structure; iv) resilience to short-term shocks; v) banking sector performance; vi) financial imbalances; vii) environmental risks; and viii) institutional and political risks.
Combined relative credit weaknesses identified in the QS generate a three-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).
Environment-related credit risks for Cyprus are elevated. Cyprus is particularly vulnerable to the adverse effects of climate change due to droughts, water scarcity and extreme temperatures given its position as a small Mediterranean island state. In addition, the country faces meaningful transition risks. Even though it accounts for just 0.26% of total GHG emissions in the EU, Cyprus’s economy is among the most carbon intensive in the EU. Total greenhouse gas emissions have increased substantially compared to 1990, and both its greenhouse gas intensity and its emissions per capita are above the EU average. 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. This is compounded by the physical constraints of its position as a small island state with limited natural resources and a rapidly growing population and economy which pose environmental sustainability concerns, as highlighted by the European Commission7 . 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 86% of its gross inland energy consumption in 2020. The share of renewable energy reached 13.8% in 2019 and the country’s renewable energy target of reaching 22.9% share by 2030. 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 a proposed carbon tax. These efforts will be supported by the RRP that includes reforms and investments to green the economy which will be critical to ensuring the environmental sustainability of Cyprus’s growth model.
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. Cyprus performs relatively well in terms of poverty and income inequality relative to peers. Cyprus has posted one of the strongest improvements among EU countries regarding the share of the population which is at risk of poverty or social exclusion over the last five years. Cyprus performs poorly in terms of education outcomes, with its PISA scores ranking consistently among the lowest EU performers despite spending more on education than other EU countries (5.4% of GDP versus a 4.7% EU average). In addition, Cyprus’s human capital performs poorly in terms of digitalisation capacity with shortfalls in terms of available ICT specialists and digital skills among nationals. The underperformance of the education system despite relatively high public spending weighs on human capital formation and could constitute an impediment to future growth and diversification of the economy. Similarly, youth unemployment and the number of young people not in employment education or training remain at high levels.
In terms of governance related factors, the country benefits from relatively strong performance on the World Bank’s Worldwide Governance Indicators though it underperforms the EU average. The president, Níkos Anastasiádis, was re-elected in 2018 for another 5-year term although with continued minority control over parliament following legislative elections in 2021. Only 17 of 56 seats are currently held by the Democratic Rally, the president’s party. Geopolitical risks persist on the island in view of the division of the country between Greek and Turkish speaking communities. Negotiations over the reunification of the country have been deadlocked 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. The political shift in Northern Cyprus towards a more nationalist leadership and increasingly antagonistic actions by Turkey are likely to hamper progress towards a UN-led solution.
The main points discussed by the rating committee were: i) growth dynamics and economic prospects; ii) fiscal performance and debt trajectory; iii) financial system risks; iv) exposure to Russia and Ukraine; and v) geopolitical developments.
Rating driver references
1. Cypriot Ministry of Finance (2021), Stability Programme Update 2021-24
2. Cypriot Ministry of Finance (2021), Cyprus Recovery and Resilience Plan 2021-26
3. International Monetary Fund (2022), Cyprus: Staff Report for the 2022 Article IV Consultation
4. Cypriot Ministry of Finance (2021), Stability Programme Update 2021-24
5. Cypriot Public Debt Management Office (2021), Medium-Term Public Debt Management Strategy 2022-24
6. Cypriot Public Debt Management Office (2022), Annual Funding Plan 2022 (1st update)
7. European Commission (2022), 2022 Country Report - Cyprus
The methodology used for these Credit Ratings and/or Outlooks, ( Sovereign Ratings Methodology, 8 October 2021), is available on https://www.scoperatings.com/ratings-and-research/structured-finance/methodologies.
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-governance/definitions-and-scales. 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/eu-regulation. 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-governance/definitions-and-scales. 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/ratings-and-research/structured-finance/methodologies.
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.
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, Associate Director
Person responsible for approval of the Credit Ratings: 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 14 January 2022.
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.
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