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Rating action

Scope Ratings GmbH (Scope) has today upgraded the Republic of Cyprus’s (Cyprus) long-term issuer and senior unsecured local- and foreign-currency ratings to BBB+ from BBB and maintained the Stable Outlook. 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 upgrade Cyprus’ credit ratings to BBB+ from BBB reflects:

1. A very favourable debt trajectory resulting in steadily decreasing debt levels, supported by strong growth, resilient fiscal performance with a return to budget surpluses already by year-end 2022 and a commitment to continued fiscal discipline.
    
2. Better-than-expected economic performance, which continues to show resilience amid the adverse external environment and inflationary pressures, with solid medium to long-term growth prospects compared to peers, also underpinned by sound structural reform momentum and public investments under the national reform agenda and Recovery and Resilience Plan.
    
3. Sustained improvements in the financial sector, with a reduced banking sector size overall as well as banks’ NPL ratios declining even amidst the Covid-19 and cost-of-living crises, strengthening capitalisation levels.

The BBB+ rating is constrained by Cyprus’s: i) small, open, and externally dependent economy; ii) lingering albeit improving vulnerabilities in the banking sector, as reflected in still elevated non-performing exposures; and iii) high sensitivity to shocks due to large macro-economic imbalances, reflected in high levels of private and public debt, combined with a weak external position.

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

The ratings/Outlooks could be upgraded if, individually or collectively: i) banking sector and/or macroeconomic vulnerabilities related to high private and external debt are reduced materially; ii) fiscal discipline is maintained, resulting in a material decline in public debt; and/or iii) economic resilience is strengthened sustainably, for instance through the development of high value-added export sectors or lower energy import dependence.

Conversely, the ratings/Outlooks could be downgraded, if individually or collectively: i) the debt trajectory weakens, for instance due to fiscal loosening or the crystallisation of contingent liabilities; ii) the growth outlook deteriorates substantially; iii) banking sector fragilities re-emerge posing risks to the economy and/or the sovereign balance sheet; and/or iv) external finances deteriorate substantially, for instance due to an external shock or heightened commodity price volatility.

Rating rationale

The first driver of the upgrade to BBB+ is Cyprus’s strong fiscal performance and resilience despite ongoing headwinds related to the cost-of-living crisis. The budget balance outperformed in 2022, improving markedly to 2.6% of GDP after -1.9% of GDP in 2021 (+4.5pps). This was achieved despite the fiscal cost of measures adopted to counter the cost-of-living crisis (estimated at 0.7% of GDP) and represents the strongest improvement in budgetary performance among EU countries. The rapid increase in revenue (+13.7%) on the back of the economic rebound, a strong labour market and increases in private consumption, was the main driver, while spending growth was contained at 3%. Expenditures are rising due to the indexation of public wages and pensions to inflation and the government’s support measures to mitigate the cost-of-living crisis for households and businesses, though this is mitigated by the buoyant revenue expansion. Preliminary fiscal results show the general government balance recording a surplus of 3.1% of GDP in the nine months to September 2023, versus 2.6% of GDP a year prior¹.

The government’s budgetary strategy aims at maintaining fiscal support for the economy near-term, whilst preserving fiscal sustainability through a sound fiscal position in the medium term and achieving debt consolidation². Cyprus’s resilient economic and fiscal performance in the post-Covid period anchor Scope’s expectations of sustained fiscal surpluses in coming years. This is further underpinned by the country’s good record of fiscal discipline and the large primary surpluses prior to the Covid-19 crisis, which averaged 2.4% of GDP over 2015-19, and strong commitment to prudent budgetary policies, as reflected in the Stability Programme 2023-25 and Draft Budget 2024. Scope forecasts solid budget surpluses of around 2.3% of GDP on average over 2023-28, the strongest fiscal performance foreseen of all EU countries.

As a result, Cyprus’s public debt burden is set shrink markedly in coming years on the back of sustained fiscal surpluses, strong growth, and to a lesser extent moderately elevated inflation. The country’s debt-to-GDP ratio already declined to 88% of GDP in 2022, down 25pps from 2020 peaks. Scope’s baseline debt sustainability scenario forecasts a steady and rapid debt consolidation in coming years, with public debt reaching the 60% Maastricht threshold by 2026 and declining further to 50% by 2028, converging with that of Malta (A+/Stable; 52% of GDP in 2022). This represents the fastest expected reduction in public debt over 2022-28 of all EU member states and would provide Cyprus with substantial fiscal buffers to face future shocks. The declining debt trajectory is robust to a combined macro-fiscal and interest rate shock, including a two-year recession in 2024-25, with debt stabilising in 2023-2025 and thereafter steadily declining to 72% of GDP by 2028 under more adverse conditions. Importantly, Cyprus would be among the few EU countries whose interest burden Scope projects to decline modestly in coming years, despite higher prevailing funding rates. Cyprus’s large cash buffer of around 10% of GDP at end-2022 exceeds the financing needs of 2023 and provides an additional buffer for any debt-related or refinancing risks³. Overall, these developments underpin Scope’s expectation that Cyprus will continue to reduce its public debt burden in coming years and further bolsters the decision the upgrade its ratings to BBB+.

The second driver of the upgrade to BBB+ is Cyprus’s strong economic fundamentals. The economy has outperformed expectations and has demonstrated its resilience to shocks in recent years, posting growth of 5.6% in 2022, after 6.6% in 2021. Domestic demand has benefitted from pent-up demand, a strong labour market, and growth across virtually all economic sectors. Faster-than-expected recovery in tourism supports exports after the country successfully diversified away from Russia towards other target markets. Inflation is normalising, having reached 3.3% in October 2023, down from 6.8% in January. Similarly, labour markets remain tight, with unemployment of 6.2% in September 2023, below pre-Covid pandemic levels, while the employment rate for those aged 20 to 64 years old stood at a historical high of 79.2% in June.

Looking ahead, the government’s Long-Term Economic Strategy for sustainable growth, investments and structural reforms under its Recovery and Resilience Plan will be critical for underpinning strong medium- and long-term growth and reducing reliance on lower value-added service sectors. The strategy identifies sectors and policies that can drive future growth in an environmentally and socially sustainable manner, setting the course for greater diversification and economic resilience. After receiving a disbursement of EUR 157m in Recovery and Resilience Facility prefinancing, Cyprus secured a second disbursement of EUR 85m in December 2022, having successfully completed 14 milestones, though more progress is needed to unlock the remaining EUR 958m. Measures to facilitate the digital transition, strengthen productivity growth and boost export-oriented sectors have been introduced. Authorities also passed important legislation for a broad reform of the justice system and launched reforms to enhance the performance of public administration.

Scope expects real growth to slow to 2.3% in 2023 due to near-term headwinds before rising again and stabilising at around 3% through 2028 as tourism recovers fully, price dynamics ease, external demand recovers, and the economic benefits of rising public investment and structural reforms materialise. Rising private investments should also act as a major driver of growth, given a substantial pipeline of investment projects. At around 3%, Cyprus’s medium-run growth potential is among the highest of euro area peers and provides the country with solid economic foundations for medium-term fiscal consolidation.

The final driver of the upgrade to BBB+ reflects continued reductions in banking sector vulnerabilities. The nonperforming loan (NPL) ratio reached 7% in June 2023 down from 9.3% in June 2022 and from the 2015 peak of 48%, according to IMF data. Importantly, the NPL ratio has continued to improve in the wake of the Covid-19 pandemic and the cost-of-living crises. In addition to improved asset quality, the Cypriot banking sector is better positioned to face shocks given of stronger capitalisation levels, with the tier 1 ratio continuing to improve and reaching an all-time high of 21% in June 2023, versus 19.5% in June 2022. In addition, the size of the banking sector declined further to 236% of GDP, versus 631% in 2012. Contingent liabilities linked to the guarantees granted to the financial sector stand at around 1.5% of GDP, versus 11.8% in 2019. As such, the risks stemming from Cyprus’s banking sector to the sovereign have declined in recent years, supporting the country’s credit quality. Still, banking sector vulnerabilities remain a core credit challenge and could worsen in a context of higher inflation and interest rates, while further reductions in NPLs are complicated by implementation delays in the Foreclosure Law, and frequent suspensions of foreclosures.

Beyond lingering banking sector vulnerabilities, Cyprus’s BBB+ rating is constrained by additional factors.

First, Cyprus’s small, open 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 historically. These sectors are heavily reliant either on external demand or foreign funding. Vulnerability to external shocks is high given that the nearly two thirds of real gross value-added and employment are tied to these sectors. An adverse scenario whereby the global economic outlook deteriorates substantially and external demand drops could leave Cyprus more exposed than peer countries. In addition, the country’s energy import dependence is high, with close to 90% of its energy needs being met thanks to imports in 2021. Scope notes positively that Cyprus’s economic resilience has outperformed expectations in the context of the Covid-19 pandemic and the cost-of-living crises. Successful implementation of reforms under the national recovery plan and long-term economic strategy is nevertheless critical to reallocate resources to other promising high value-added sectors such as higher education, renewable energies, agri-tech, health, or ICT solutions.

Second, large macro-economic imbalances, including still high levels of private and external debt constrain the BBB+ ratings. Household debt, at 69% of GDP in Q2 2023, is the fifth highest in the EU, although it is well below the 2015 peak of 131% of GDP. Nonfinancial corporate debt levels, although declining in recent years from the 2015 peak of 223% of GDP, remain very high with financial liabilities standing at 142% of GDP as of Q2 2023, well above the euro area average (around 80% of GDP).

Finally, Cyprus’s external position continues to be characterised by large imbalances. Sustained current account deficits have resulted in a net international investment position of -102% of GDP as of Q2 2023, while external debt stands at 604% of GDP as of June 2023. The current account deficit widened to 7.9% of GDP in 2023, after narrowing to 6.1% of GDP in 2021 from 10% of GDP in 2020, due to higher imports and associated prices while exports have yet to fully recover. Scope expects current account deficits to narrow modestly but remain above their historical averages, at around 8% of GDP through 2028. External imbalances are somewhat overstated due to the prevalence of special purpose entities that have a limited link to the real economy. That said, they remain an important source of risk. These factors 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 ‘a-’ as regards Cyprus. The ‘a-’ indicative rating is further supported by the methodology’s reserve currency adjustment which provides a one notch uplift to the CVS. The ‘a’ indicative rating 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 have been identified: i) growth potential of the economy; ii) fiscal policy framework. Conversely, the following relative 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 factors; and viii) governance factors.

Combined relative credit 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 25% weighting under the quantitative model (CVS).

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 greenhouse gas (GHG) emissions in the EU, Cyprus’s economy is among the most carbon intensive in the EU. Total greenhouse gas emissions have decreased by 4.1% compared to 2005, 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 Cyprus’s non-Emission Trading Scheme GHG emissions exceeding its annual allocation in 2021. Existing policies would only achieve a 7% reduction in emissions versus 2005 levels, while planned policies would achieve a 17% reduction, both well below Cyprus’s effort sharing target of 32%⁴. 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. 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 88% of its total energy supply in 2020. 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, Cyprus performs relatively well in terms of income inequality and labour force participation in Scope’s quantitative model, while population ageing is a challenge. Cyprus has posted one of the strongest improvements among EU countries regarding the share of the population at risk of poverty or social exclusion, reducing this ratio by 7.6pps to 21.3% over 2015-20. 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 (5.5% of GDP versus a 4.8% 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. Presidential elections in February 2023 saw the victory of independent candidate Nikos Christodoulides for a 5-year term with the backing of centrists and centre-right parties. The administration will have to contend with continued minority control over parliament, with the government coalition holding only 16 of 56 seats, though the country has proven its capacity to achieve consensus-based policymaking. Scope expects broad policy continuity in coming years. Institutional reforms to support transparency in decision-making and on the protection of whistle-blowers are positive steps in bolstering governance but more progress is needed. 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, although unofficial dialogue remains open. 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 an UN-led solution, though the administration in the Republic of Cyprus is looking to revive talks with EU support.

Rating Committee
The main points discussed by the rating committee were: i) economic resilience and outlook; ii) fiscal performance and prospects; iii) debt trajectory and sensitivities; iv) banking sector developments; and v) geopolitical risks.

Rating driver references
1. Statistical Service of Cyprus (2023), Fiscal Accounts of General Government: Jan-Sep 2023
2. Cypriot Ministry of Finance (2023), Stability Programme Update 2023-26
3. IMF (2023), 2023 Article IV Staff Report: Cyprus
4. European Commission (2023), 2023 Country Report: Cyprus

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Sovereign Rating Methodology, 27 September 2023), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The model used for these Credit Ratings and Outlooks is (Core Variable Scorecard Model Version 2.1), available in Scope Ratings’ list of models, published under https://scoperatings.com/governance-and-policies/rating-governance/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://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://scoperatings.com/governance-and-policies/rating-governance/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      YES
With access to internal documents                                    YES
With access to management                                              NO
The following substantially material sources of information were used to prepare the Credit Ratings: public domain and the Rated Entity.
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 Outlooks and the principal grounds on which the Credit Ratings and 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, Associate Director
Person responsible for approval of the Credit Ratings: Alvise Lennkh-Yunus, Executive Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 19 October 2018. The Credit Ratings/Outlooks were last updated on 9 December 2022.

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

Conditions of use / exclusion of liability
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