Rating action

Scope Ratings GmbH (Scope) has today upgraded the Republic of Cyprus’ (Cyprus) long-term issuer and senior unsecured debt ratings to A- from BBB+ in local and foreign currency, and maintained the Stable Outlooks. The short-term issuer ratings have been upgraded to S-1 from S-2 in both local and foreign currency, with Stable Outlooks.

The upgrade of Cyprus’ long-term ratings is driven by:

1. The strong fiscal outlook characterised by sustained primary surpluses and declining general government debt. The improvement in public finances, which was interrupted by the Covid-19 pandemic and cost-of-living crisis, has resumed and is expected to continue, supported by further revenue growth and well-anchored net interest payments. The strengthening of fiscal buffers enhances budget flexibility to tackle demographic and climate-related challenges, and increases resilience to external shocks;
    
2. The robust economic growth that is expected to remain above the euro area average and credit rating peers. The strong performance is driven by solid growth prospects in key sectors, including financial and business services, tourism and construction, as well as increased economic diversification through the expansion of the information and communication technology (ICT) sector. Recent amendments of the immigration law also raise the prospects for a continued inflow of high skilled foreign workers supporting further economic diversification;
    
3. The reduction in financial system risks. Despite persistent vulnerabilities, banks’ balance sheets have been supported by the improvement of their profitability, asset quality, capital levels and liquidity metrics, signalling steady progress towards tackling the legacy of the 2012-13 financial crisis. This continues to strengthen the sector’s shock absorption capacity and mitigates contingent liability risks on the sovereign balance sheet.

The Stable Outlook reflects Scope’s view that the credit ratings already capture a favourable fiscal outlook, declining government debt and robust economic prospects. Upward pressure on the ratings would require stronger macroeconomic stability driven by the rebalancing of external accounts and further progress to reduce the non-performing loans (NPL) ratio towards euro area average.

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Key rating drivers

Strong fiscal outlook characterised by sustained primary surpluses and declining general government debt. Cyprus displays a strong record in meeting or overshooting fiscal targets, as reflected in large primary surpluses prior to the Covid-19 pandemic (2.4% of GDP on average between 2014 and 2019) and after the cost-of-living crisis (4.1% of GDP on average between 2022 and 2023, despite spending related to the Cost-of-Living Allowance and temporary support measures). The general government surplus reached 4.3% of GDP between January and August 2024¹, up from 3.0% over the same period in 2023, thanks to a strong labour market resulting in high income tax revenues and higher social security contribution rates. Despite delays in phasing out electricity subsidies and VAT exemptions, introduced to offset high inflationary pressures on household incomes, Scope projects a surplus of 3.1% of GDP in 2024 and 3.0% in 2025.

For the period 2026-29, Scope projects an average fiscal surplus of 1.8% of GDP based on prudent budgetary policies and the commitment to maintain the current fiscal stance. Revenue growth is expected to be driven by a robust economic outlook, social security contributions, and the prospects of tax reforms in line with Cyprus’ Recovery and Resilience Plan, including green taxation. Despite delays in transposing the EU’s Minimum Tax Directive², the amendment of the national law is likely to become effective, providing a boost to tax revenues. The solid revenue prospects help to address spending pressures resulting from an ageing population and the climate transition, which are estimated to cost around 2.5% of GDP by 2030³. Moreover, the long average debt maturity and limited financing needs mean that tighter funding conditions are expected to have a benign impact on net interest payments, which are anchored at around 1.4% of GDP by 2029 (2.5% on average between 2014 and 2019). Finally, Cyprus’ fiscal position is further strengthened by comfortable cash reserves of more than 10% of GDP, bolstering resilience against external headwinds.

Strong fiscal performance and robust growth prospects drive a firm deleveraging path. General government debt-to-GDP, which decreased from a peak of 115.0% in 2020 to 77.3% in 2023, is expected to decline further, below 60% by 2026 and below 50% by 2029, or a decrease of about 45pps over 10-years. This is one of the strongest performances relative to euro area and rating peers. Moreover, the recent revision of national accounts could further support the declining trajectory of general government debt.

Robust economic growth outlook above that of euro area and credit rating peers. Real GDP growth is projected at 3.2% in 2024, up from 2.5% in 2023, and 3.1% in 2025. Robust private demand, supported by the decline in inflation, lower interest rates, and a low unemployment rate of 4.6% is expected to drive economic growth. Strong economic performance will also be supported by growth in key sectors such as financial-business services, tourism and shipping services. Moreover, labour intensive sectors, such as construction and tourism, are expected to be supported by a dynamic residential real estate sector, robust international tourist arrivals and an inflow of foreign workers mitigating domestic labour shortages.

Furthermore, export services are likely to be driven by solid growth prospects in financial-business services and in the fast-growing ICT sector. The amendment of the civil registry law for acquiring citizenship by naturalisation⁴ are expected to create more attractive conditions for high skilled foreign workers, contributing to address skills-mismatches and raising the prospects for sustained foreign direct investment.

Moreover, public investment is expected to be supported by the EU Recovery and Resilience Plan ending in 2026, with only about 22% of grants and loans (around 4% of GDP) disbursed to date⁵. This could further increase Cyprus’ growth potential, currently estimated at 3%, which is high relative to euro area and rating peers. Finally, the prospects for natural gas production starting in 2026 could further contribute to economic diversification, while improving energy security and external accounts.

Reduction in financial system risks, reflected in the continuous improvement of the private and banking sectors’ financial position. Private sector debt remains high (66% of GDP for households and 82% for non-financial corporates) but has declined since 2016 by 50pps for households and 58pps for non-financial corporates adjusted for Special Purpose Entities (SPEs). The improvement of the private sector’s financial position is also reflected in the steady decrease in NPLs throughout the Covid-19 pandemic and cost-of-living crisis (8.7% for households and 5.9% for non-financial corporates), although it remains among the highest in the euro area. Moreover, negative credit growth in recent years indicates a lower dependence on bank lending, while the private sector is expected to benefit from lower interest rates as household and non-financial corporate debt is largely held at floating rates. Households’ financial position is also supported by a strong labour market, robust wage growth supporting real incomes amid lower inflation, and higher residential property prices.

Furthermore, a record of structural reforms and the consolidation of the banking sector have bolstered financial metrics of Cypriot banks, which are expected to remain well-above minimum regulatory requirements. Capital levels have improved, with the common equity Tier 1 ratio rising from less than 20% in March 2023 to more than 23% in March 2024. Profitability has been supported by higher interest rates, with a return on equity rising to around 25% in 2023, while liquidity buffers are anchored by significant cash and liquid asset holdings. Asset quality is expected to improve further thanks to the implementation of the foreclosure framework passed into law in 2023, enabling the transfers of NPLs to credit acquiring companies, while banks have increased the provisions. Although the banking sector is large, with assets accounting for 205% of GDP, the stronger financial metrics enhance its shock-absorption capacity⁶ and help to mitigate contingent liability risks.

Rating challenges: small, opened and externally dependent economy vulnerable to shocks; external position characterised by large imbalances. Cyprus’ A- credit ratings are constrained by its small, open economy that remains reliant on a few externally driven sectors that are vulnerable to external headwinds. The high dependence on foreign workers, energy imports and external demand increases Cyprus’ vulnerability to some key trading partners that are exposed to heightened geopolitical tensions.

Cyprus’ A- credit ratings are also constrained by structurally large current account deficits, reflecting high imports needs, moderate savings relative to domestic investment and high repatriation of profits by foreign-owned companies. This drives a highly negative net international investment position⁷, high gross external debt and external financing requirements. Even so, Cyprus’ euro area membership, inflow of foreign direct investment, significantly more favourable external metrics – when adjusted for SPEs – and prospects for energy exports help to mitigate risks.

Outlook and rating sensitivities

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

Upside scenarios for the ratings and Outlooks are (individually or collectively):

1. Significantly stronger macroeconomic stability due to, for example, economic diversification and lower external imbalances, enhancing resilience against external shocks;
    
2. Significantly stronger financial sector outlook due to, for example, a resolution of the financial crisis legacy including a reduction of still high levels of non-performing loans;
    
3. Further improvement in fiscal dynamics at a significantly faster rate than presently forecasted, driving an accelerated decline in general government debt.

Downside scenarios for the ratings and Outlooks are (individually or collectively):

1. Weaker fiscal outlook due to, for example, a loosening of the fiscal stance challenging the expected decline in general government debt;
    
2. Weaker macroeconomic stability due to, for example, more pronounced external imbalances, undermining the shock absorption capacity;
    
3. Weaker financial sector outlook due to, for example, the resurgence of banking sector’s vulnerabilities.

Sovereign Quantitative Model (SQM) and Qualitative Scorecard (QS)

Scope’s SQM, which assesses core sovereign credit fundamentals, signals a first indicative credit rating of ‘a’ for Cyprus. Under Scope’s methodology, the indicative rating receives 1) a one-notch positive adjustment from the methodological reserve-currency adjustment; and 2) no negative adjustment from the methodological political-risk quantitative adjustment. On this basis, a final SQM quantitative rating of ‘a+’ is reviewed by the Qualitative Scorecard (QS) and can be changed by up to three notches depending on the size of Cyprus’ qualitative credit strengths or weaknesses compared against a peer group of sovereign states.

Scope has identified the following QS relative credit strengths for Cyprus: i) growth potential and outlook; ii) fiscal policy framework; and iii) long-term debt trajectory. Conversely, the following relative weaknesses have been identified: i) macroeconomic stability and sustainability; ii) current account resilience; iii) external debt structure; iv) resilience to short-term external shocks; v) banking sector performance; vi) financial imbalances; vii) environmental factors; and viii) governance factors.

On aggregate, the QS generates a 2-notch negative adjustment and signals A- credit ratings for Cyprus.

A rating committee has discussed and confirmed these results.

Environment, social and governance (ESG) factors

Scope explicitly factors in ESG issues in its ratings process vis-à-vis the sovereign-rating methodology’s stand-alone ESG sovereign-risk pillar, which holds a significant 25% weighting under the quantitative model (SQM) and 20% weight under the methodology’s qualitative overlay (QS).

With respect to environmental factors, Cyprus is vulnerable to the adverse effects of climate change, which could be damaging for sectors such as tourism and agriculture. As a small island state, Cyprus also faces meaningful transition risks with one of the most carbon intensive economies in the EU. Plans to reduce reliance on fossil fuels include a long-term strategy for building renovations, a renewable energy roadmap, investments to encourage a shift towards green mobility, and a carbon tax. However, despite the vast supply of renewable sources of energy, investment is lagging to gradually raise the share of renewable energy sources to one-third by 2030. This drives a ‘weak’ assessment relative to credit rating peers.

As regards social-risk factors, Cyprus performs relatively well in terms of income inequality and labour force participation, 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. Even so, Cyprus performs poorly in terms of educational outcomes, with its PISA scores ranking consistently among the lowest EU performers. Cyprus’ human capital also performs poorly in terms of digitalisation capacity with shortfalls in terms of available ICT specialists and digital skills among nationals. Youth unemployment and the number of young people not in employment, education or training remain at high levels. This drives a ‘neutral’ assessment relative to credit rating peers.

Under governance-related factors, Cyprus benefits from relatively strong performance on the World Bank’s Worldwide Governance Indicators. 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 faces continued minority control over parliament, though the country has a proven track-record of consensus-building. Institutional reforms to support transparency in decision-making and on the protection of whistleblowers help to improve governance. However, the longstanding geopolitical tensions with Türkiye persist. This drives a ‘weak’ assessment relative to credit rating peers.

Rating committee
The main points discussed by the rating committee were: i) domestic economic risk; ii) public finance risk; iii) external economic risk; iv) financial stability risk; v) ESG-related risk; and vi) rating peers.

Rating driver references
1. Republic of Cyprus, Statistical Service, Fiscal Accounts of General Government, October 2024
2. European Commission, Press Release, October 2024
3. IMF, 2024 Article IV Consultation, May 2024
4. European Commission, Cyprus: New citizenship legislation, March 2024
5. European Commission, Disbursements, Recovery and Resilience Scoreboard, October 2024
6. European Central Bank, Stress tests, 2023
7. Central Bank of Cyprus, External Statistics, October 2024

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Sovereign Rating Methodology, 29 January 2024), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The model used for these Credit Ratings and Outlooks is (Sovereign Quantitative Model Version 4.0), 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                                            YES
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 and Outlooks 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: Thomas Gillet, Director
Person responsible for approval of the Credit Ratings: Eiko Sievert, Senior Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 19 October 2018. The Credit Ratings/Outlooks were last updated on 17 November 2023.

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, as well as a list of Ancillary Services and certain non-Credit Rating Agency services provided to Rated Entities and/or Related Third Parties.

Conditions of use/exclusion of liability
© 2024 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Fund Analysis GmbH, and Scope ESG Analysis 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.