DBRS Confirms Republic of Cyprus at BBB (low), Stable Trend

DBRS Ratings Limited (DBRS) confirmed the Republic of Cyprus’s Long-Term Foreign and Local Currency – Issuer Ratings at BBB (low). At the same time, DBRS confirmed the Republic of Cyprus’s Short-Term Foreign and Local Currency – Issuer Ratings at R-2 (middle). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS

The confirmation of the Stable trend reflects DBRS’s view that while the Cypriot economy continues to perform robustly, more progress is needed to reduce risks to financial stability further. Cyprus’s real GDP growth was 3.9% in 2018, among the strongest in the Euro area, and the forecast for 2019 is 3.6%. Last year, Cyprus made significant progress in reducing vulnerabilities in the banking sector, reflecting the government’s and the banks’ stepped up efforts. Together, the orderly liquidation of Cyprus Cooperative Bank and the banks’ sale of non-performing exposures (NPEs) almost halved the stock of the banking sector’s NPEs in 2018. Later this year, the government is set to implement its social scheme (‘ESTIA’) aimed at addressing NPEs related to retail mortgages, which remain very high.

The BBB (low) ratings are supported by Cyprus’s solid budget position, its prudent 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 NPEs in the banking sector, 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 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 substantially reducing banks’ NPEs 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 NPEs could also be negative.

RATING RATIONALE

The Cypriot Economy Continues to Perform Strongly

Cyprus’s economic growth in 2018 remained strong. Since 2015, annual real GDP growth has averaged 3.8%. Growth has been largely driven by private consumption and investment, and has been broad-based, with construction, tourism, shipping, professional services, and manufacturing, making a contribution. Employment growth has also been strong, the unemployment rate has fallen to 7.1% in February 2019, and wages are rising. This, together with low inflation, is supporting disposable incomes. In 2019, growth is forecast to moderate to 3.6%. Private consumption is expected to be weighed down by debt repayments and contributions to the new national health system. Downside risks to the outlook are related to a less favourable external environment and adverse developments in the financial sector, while upside risks include the broader economic impact from a large casino-resort, currently under construction, and other projects.

Cyprus’s capacity to grow has improved in recent years, with potential GDP growth rising close to 2.5%, according to IMF estimates. 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.

Risks to Financial Stability Have Declined But Remain Relatively High

Cypriot banks’ NPEs declined materially in 2018. The stock of the banking sector’s NPEs, as reported by the Central Bank of Cyprus (in line with the definition of the European Banking Authority), dropped from EUR 20.9 billion in December 2017 to EUR 10.4 billion in December 2018. The largest reduction in banks’ NPEs 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 5.8 billion of NPEs from the Cypriot banking system. These NPEs are now in the state’s Asset Management Company (AMC) and expected to be disposed of over time.

Cypriot banks also stepped up their efforts to reduce NPEs. Supported by the strengthened legal framework, Bank of Cyprus, the largest bank in the country, sold an NPE portfolio of EUR 2.7 billion in 2018. This follows Hellenic Bank’s NPE 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”). Total deposits fell modestly last year, but largely driven non-residents. Moreover, Cypriot banks returned to profitability in 2018, and their capital levels and loss loan provisioning have been raised to adequate levels.

The government has also made progress in the other two pillars of its strategy to reduce NPEs. In addition to selling CCB and managing the assets in the residual entity, the government strengthened the insolvency and foreclosure framework and the sales-of-loans law, and adopted a law on securitisations in July 2018. The third pillar of the strategy involves addressing NPEs related to retail mortgages through a social scheme (‘ESTIA’), designed to help only eligible households repay their loans, and thus exclude strategic defaults. The European Commission approved the scheme in December 2018, and the government now expects to implement the scheme, currently under legal vetting, in the second half of 2019. According to the government, up to EUR 3.4 billion of NPEs could be eligible to participate in the scheme (which would include a large part of the AMC’s NPEs), helping to reduce NPEs in the Cypriot economy.

Nevertheless, high NPEs and private sector debt remain the main risk to financial stability in Cyprus. Despite the material reduction of in the stock of NPEs – by 64% from their 2015 peak to December 2018 – NPE ratios remain high. The banking system’s NPEs were 30.5% of total loans in December 2018, down from a 49.0% peak in May 2016. In part, this reflects the reduction in bank loan portfolios as households and businesses deleverage. The reduction in NPEs has been largely driven by the corporate sector. The decline in household NPEs, which account for more than half of total NPEs, has been limited. DBRS expects further progress in NPE reduction, driven by the government’s ESTIA scheme, banks’ efforts, falling unemployment, rising house prices, and solid economic growth. Driven by the strengthening Cypriot economy, the housing market continued to recover in 2018, with prices growing by 1.8%.

The Public Debt Ratio Is Set to Resume Its Downward Trend and The Sound Fiscal Performance to Be Maintained

Following early loan repayments to the Central Bank of Cyprus and the IMF, the government debt-to-GDP ratio fell below 100% in 2017 for the first time since 2013. In 2018, however, the debt ratio was 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”). After increasing to 102.5% in 2018, the debt ratio is projected to resume its downward trend from this year, falling to 95.7% in 2019 and 89.1% in 2020, driven by large primary surpluses of around 5% of GDP and solid growth.

While the main direct fiscal impact from government’s NPE reduction strategy has come from the bonds issuance in 2018, there are also other effects. The fiscal cost from the ‘ESTIA’ scheme, which involves subsidising one third of eligible borrowers’ restructured loan repayments, has an estimated annual cost of 0.1% of GDP over 25 years. This impact is limited. Additionally, 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, particularly a materialisation of contingent liabilities, public debt management is prudent. 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% in April 2019 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, and following a one-off negative effect on the fiscal balance in 2018, the government is targeting a surplus of 3.0% in 2019 and 2.6% in 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 sound institutions. The government also remains committed to addressing the country’s challenges. The government lacks a majority in the House of Representatives, and this has resulted in delays in adopting pending reforms, including those of the public administration and the local governments. The government, nevertheless, managed to get approval of the legislation related to its strategy for the reduction of the NPEs in July 2018. The reform of the judicial system to improve its efficiency, and which should enhance the efforts for the NPEs reduction, is ongoing.

External Imbalances Persist But Are Contained

Given its small economy, Cyprus’s current account is influenced by large exports and imports of transport equipment related to investment, mainly ships. Cyprus’s current account improved in 2018, recording a deficit of 7.0% of GDP compared to a deficit of 8.4% in 2017, mainly driven by higher growth in exports of goods. Cyprus’s negative net international investment position (NIIP) remained large at 115% of GDP in 2018 but it continues to improve. The current account deficit and the NIIP reflect in large part activities in the international business centre and special purpose entities (SPEs) operating in the shipping sector, with limited links to the domestic economy. Adjusted for the impact of SPEs transactions, the current account deficit was 4.5% of GDP and the negative NIIP was 38.2% in 2018.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the BBB (high) – BBB (low) 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): -4.8 (2018); 3.0 (2019F); 2.6 (2020F)
Gross Debt (% GDP): 102.5 (2018); 95.7 (2019F); 89.1 (2020F)
Nominal GDP (EUR billions): 20.7 (2018); 21.7 (2019F); 22.6 (2020F)
GDP per Capita (EUR): 23,974 (2018); 25,117 (2019F); 26,109 (2020F)
Real GDP growth (%): 3.9 (2018); 3.6 (2019F); 3.2 (2020F)
Consumer Price Inflation (%): 0.8 (2018); 0.5 (2019F); 1.2 (2020F)
Domestic Credit (% GDP): 315.9 (2017); 289.5 (Sep-2018)
Current Account (% GDP): -7.0 (2018); -7.8 (2019F); -8.2 (2020F)
International Investment Position (% GDP): -121.1 (2017); -114.7 (2018)
Gross External Debt (% GDP): 552.3 (2017); 494.6 (2018)
Governance Indicator (percentile rank): 77.9 (2016); 79.8 (2017)
Human Development Index: 0.87 (2016); 0.87 (2017)

EURO AREA RISK CATEGORY: Low

Notes:

All figures are in euro (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Fiscal balances include one-offs. Excluding one-off support measures related to Cyprus Cooperative Bank, the fiscal surplus is estimated at 3.2% of GDP in 2018. Fiscal balance (Ministry of Finance), Gross debt (Ministry of Finance), Nominal GDP (Ministry of Finance), GDP per Capita (Ministry of Finance/European Commission), Real GDP Growth (Ministry of Finance), Inflation (Ministry of Finance), Domestic Credit (Central Bank of Cyprus), Current Account (Ministry of Finance), International Investment Position (Central Bank of Cyprus), Gross External Debt (Central Bank of Cyprus). 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 Cyprus 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, OECD, 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: 23 November 2018

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