DBRS Upgrades Republic of Cyprus to BBB (low), Trend Changed to Stable

DBRS Ratings Limited (DBRS) upgraded the Republic of Cyprus’s Long-Term Foreign and Local Currency – Issuer Ratings from BB to BBB (low) and its Short-Term Foreign and Local Currency – Issuer Ratings from R-4 to R-2 (middle). DBRS also changed the trend from Positive to Stable.

KEY RATING CONSIDERATIONS

The upgrade is driven by the material reduction in Cypriot banks’ non-performing loans (NPLs) in recent months, reflecting the government’s and the banks’ stepped up efforts. Together, the orderly liquidation of Cyprus Cooperative Bank and the banks’ sale of NPLs have almost halved the stock of the banking sector’s NPLs in 2018. While NPLs remain high, the decline in NPLs and a strengthened legal framework are reducing risks to financial stability. The rating upgrade is also driven by the continued solid performance of the Cypriot economy. Cyprus is on track to post real GDP growth of close to 4.0% in 2018, among the strongest in the Euro area. Growth is driven by investment, consumption and exports of services, and follows a 4.2% in 2017. Improvements in DBRS’s building blocks of “Monetary Policy and Financial Stability” and “Economic Structure and Performance” were the key factors for the rating upgrade.

In DBRS’s assessment, Cyprus’s credit fundamentals are now in line with investment grade, after recovering over the past few years. The ratings are supported by Cyprus’s solid budget position, its enhanced public debt management framework, its Eurozone membership fostering sustainable macroeconomic policies, and its openness to investment encouraging a favourable business environment. Nevertheless, Cyprus also faces significant credit challenges related to still sizable NPLs in the banking sector, still high levels of private and public sector debt, external imbalances, and the small size of its service-driven economy, which exposes Cyprus to adverse changes in external demand.

RATING DRIVERS

The Stable trend reflects DBRS’s view that risks to the ratings are currently broadly balanced. The ratings could come under upward pressure from sustained healthy economic growth and sound fiscal position, which would contribute to the downward trajectory in the public debt ratio. Moreover, further progress in reducing banks’ NPLs and private sector debt and the strengthening of the banking sector would be positive for the ratings. However, the ratings could come under downward pressure in a period of significantly weak growth, combined with large fiscal imbalances or materialisation of large contingent liabilities. A reversal of the downward trajectory in NPLs could also be negative.

RATING RATIONALE

Risks to Financial Stability Are Declining

The reduction in Cypriot banks’ NPLs accelerated in recent months. The stock of the banking sector’s NPLs, as reported by the Central Bank of Cyprus, have dropped from EUR 21 billion in December 2017 to an estimated EUR 10 billion in September 2018. This follows a decline of 28% from their peak in February 2015 to December 2017. The largest reduction in banks’ NPLs in 2018 has resulted from the resolution of state-owned Cyprus Cooperative Bank (CCB), which involved selling part of its assets to Hellenic Bank and effectively removed EUR 6.5 billion of NPLs from the Cypriot banking system. The state’s Cyprus Asset Management Company (AMC) will dispose of these NPLs over time.

The government has made progress in the other elements of its strategy to reduce NPLs. In addition to selling CCB, its three-pillar strategy is focused on: i) strengthening the effectiveness of the legal framework to tackle deficiencies in various laws and foster the development of a secondary market for NPLs; and ii) addressing NPLs related to retail mortgages (‘Project ESTIA’). In July, the Cypriot parliament passed a new law on securitisations and strengthened the insolvency and foreclosure framework and the sales-of-loans law. The government has also designed a social scheme aimed at vulnerable households to encourage them to make loan repayments and reduce strategic defaults. The implementation of the scheme is expected in early 2019. A large part of the AMC’s NPLs are set to be included in the ESTIA scheme.

Cypriot banks have also stepped up their efforts. Supported by the strengthened legal framework, Bank of Cyprus, the largest bank in the country, agreed to sell an NPL portfolio of EUR 2.7 billion. This follows Hellenic Bank’s NPL sale earlier in the year. Core domestic banks also set up independent debt servicing companies with foreign debt specialists (For further details, please see DBRS commentary “Cyprus – Acceleration in The Banking Sector’s NPL Reduction”).

Investor and depositor confidence have improved. After falling in Q1 2018, largely led by declines in non-resident deposits, total deposits in the banking system are growing again. This is driven by domestic resident deposits, which account for almost 80% of total deposits. After being negatively affected by the increase in loss loan provisioning in 2017, banks’ profitability is also improving. Moreover, banks’ capital levels are adequate.

Nevertheless, despite the material reduction of NPL stocks, NPL ratios remain high. The banking system’s NPLs were 38.9% of total loans in July 2018, down from a 49.0% peak in May 2016 (the effect from the CCB transaction is yet to be reflected in the NPL statistics as the sale was completed in September). In part, this reflects the reduction in bank loan portfolios as households and businesses deleverage. So far, the reduction in NPLs has been largely driven by the corporate sector. The decline in household NPLs, which account for more than half of total NPLs, has been limited. High NPLs and private sector debt remain the main risk to financial stability in Cyprus. DBRS expects further progress in NPL reduction, driven by banks’ efforts, the government’s policy strategy, falling unemployment, rising house prices, and solid economic growth.

The Cypriot Economy Continues to Perform Strongly

After performing strongly in the past two years, Cyprus’s economic growth has remained robust in 2018. Real GDP grew by 4.0% year-on-year in the first half of the year. Growth has been broad-based, with construction, tourism, shipping, professional services, and manufacturing, making a contribution. Unemployment is also falling and wages rising. Upwardly revised forecasts point to growth close to 4% in 2019, before moderating gradually from 2020. Downside risks to the outlook are mainly related to a less favourable external environment. Upside risks include the broader economic impact from a large casino-resort, currently under construction, and other infrastructure projects.

Cyprus’s capacity to grow has improved in recent years, with potential GDP growth rising close to 2.4%. The recovery in investment has been a key driver of the improvement. Cyprus is an attractive business services centre, shipping centre, and tourist destination. The tourism sector is diversifying into new products and markets, making it more resilient. The expected exploitation of off-shore gas reserves represents another potential source of growth in the longer term. Nevertheless, the small size of its service-driven economy exposes Cyprus to adverse changes in external demand.

Cyprus’s current account improved significantly in recent years, though it remained in deficit of 8.4% of GDP in 2017. Overall, Cyprus’s current account is influenced by large exports and imports of transport equipment related to investment (mainly ships). Cyprus’s negative net international investment position (NIIP) remained large at 121.5% of GDP in 2017 but it continues to improve. The deficit and the negative NIIP reflect in large part activities in the international business centre and SPEs operating in the shipping sector, with limited links to the domestic economy. Adjusted for the impact of SPEs, the current account deficit was 3.2% and the negative NIIP was 43.2% in 2017.

The Public Debt Ratio Is Set to Fall and The Sound Fiscal Performance to Be Maintained

Following early loan repayments to the Central Bank of Cyprus and the IMF in 2017, the government debt-to-GDP ratio fell below 100% for the first time since 2013. This year, however, the debt ratio has been impacted by the government’s issuance of domestic bonds, the funds from which were deposited with CCB to facilitate its sale. (For further details, please see DBRS commentary “Cyprus: Picking Up the Pace – Government’s Enhanced Strategy for the Reduction of NPLs”). The forecast for the debt ratio in 2018 is 104.2%. The debt ratio is projected to resume its downward trend from 2019 and reach 90.8% by 2020, driven by large primary surpluses of around 5% of GDP and solid growth.

While the main direct fiscal impact from government’s NPL reduction strategy has been the bonds issuance in 2018, there are also other effects. The fiscal cost from the ‘ESTIA’ scheme, which involves subsidies to borrowers, has an estimated annual cost of 0.2% of GDP over 25 years. This impact is limited. As part of the CCB transaction, an Asset Protection Scheme (APS) guaranteed by the state was created, increasing the government’s contingent liabilities. The APS will cover potential unexpected losses on certain assets acquired by Hellenic Bank. The government estimates that potential unexpected losses will not to exceed EUR 155 million (equivalent to 0.7% of GDP) over 12 years.

Although debt dynamics are vulnerable to adverse shocks, including a materialisation of contingent liabilities, public debt management improved in recent years. This has resulted in a favourable debt profile that reduces refinancing risks. Debt maturities have been extended and a liquidity buffer covers at least 9-month funding needs. Moreover, the weighted average cost of debt has declined, reaching 2.3% Q3 2018 compared to a peak of 4.2% in 2012.

A sound fiscal position is expected to be maintained. After accomplishing the consolidation of its budget position in a relatively short time, Cyprus is expected to maintain a healthy fiscal surplus close to 3% in 2018-2020, supported by strong revenues and contained expenditure. The government is also aiming to maintain a structural surplus, above its medium-term objective of a structural balance. Adopted reforms to strengthen fiscal management, including the reform to the wage indexation system, together with expenditure ceilings embedded in the Fiscal Responsibility and Budget Law, reinforce the sustainability of public finances.

Political Stability Supports the Government’s Capacity to Addressing Economic Challenges

Cyprus benefits from a stable political environment and institutions. The government remains committed to addressing the country’s challenges. DBRS expects continuity on fiscal policy and the debt management strategy. The government lacks a majority in the House of Representatives, and this could result in delays in adopting reforms. Despite this, the government managed to get approval of the legislation related to its strategy for the reduction of the NPLs in July 2018.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the BBB – BB (high) range. The main points discussed during the Rating Committee include non-performing loans, the performance of the banking sector, the fiscal position, the public debt ratio, private sector debt, and the economic outlook and risks to the outlook.

KEY INDICATORS

Fiscal Balance (% GDP): 1.8 (2017); 2.9 (2018F); 3.1 (2019F)
Gross Debt (% GDP): 96.1 (2017); 104.2 (2018F); 97.2 (2019F)
Nominal GDP (EUR billions): 19.6 (2017); 20.6 (2018F); 21.8 (2019F)
GDP per Capita (EUR): 22,770 (2017); 23,782 (2018F); 25,057 (2019F)
Real GDP growth (%): 4.2 (2017); 4.0 (2018F); 3.8 (2019F)
Consumer Price Inflation (%): 0.7 (2017); 1.0 (2018F); 1.2 (2019F)
Domestic Credit (% GDP): 317.2 (2017); 296.9% (Jun-2017)
Current Account (% GDP): -8.4 (2017); -9.3 (2018F); -9.7 (2019F)
International Investment Position (% GDP): -121.5 (2017); -112.1 (Jun-2018)
Gross External Debt (% GDP): 554.5 (2017); 502.4 (Jun-2018)
Governance Indicator (percentile rank): 77.9 (2016); 79.8
Human Development Index: 0.87 (2016); 0.87 (2017)

EURO AREA RISK CATEGORY: LOW

Notes:

All figures are in EUR unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Forecasts based on the 2019 Draft Budget. A large part of non-financial corporate debt relates to ship owning companies with international operations. The current account balance, external debt and the net international investment position include special purpose entities (SPEs) of shipping companies and financial companies. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include Ministry of Finance, Public Debt Management Office, Central Bank of Cyprus, Statistical Service of the Republic of Cyprus, Bank of Cyprus, Hellenic Bank, Cooperative Bank of Cyprus, European Commission, European Central Bank (ECB), Eurostat, IMF, World Bank, UNDP, Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS’s outlooks and ratings are under regular surveillance.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (“ESMA”) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings Limited are subject to EU and US regulations only.

Lead Analyst: Adriana Alvarado, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global Financial Institutions Group and Sovereign Ratings
Initial Rating Date: 12 July 2013
Last Rating Date: 25 May 2018

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