CI Ratings: Cyprus sovereign ratings affirmed

Capital Intelligence Ratings (CI Ratings or CI) has affirmed the Republic of Cyprus’ Long-Term Foreign Currency Rating (LT FCR) and Short-Term Foreign Currency Rating (ST FCR) at ‘BBB-’ and ‘A3’, respectively.

According to an announcement from the Limassol-based credit analysis and ratings agency, the outlook on the ratings also remains Stable.

Rating Rationale

CI Ratings' announcement noted that the affirmation of the ratings reflects the demonstrated resilience of the economy and stronger fiscal fundamentals, with the budget position remaining in surplus and general government debt on a firmly downward trajectory.

"The government continues to proactively manage its debt maturity profile in order to reduce refinancing risks while at the same time maintaining a substantial cash buffer to counter short-term shocks and external adversities. Government contingent liabilities from the banking sector have declined significantly in recent years, although they remain comparatively high. Other fiscal risks appear to be manageable at present, notwithstanding the challenging external environment and tightening global financial conditions. Cyprus’ ratings are also supported by the benefits of European Union and eurozone membership, including the availability of financial support from the Recovery and Resilience Facility (RRF)," the announcement said.

CI Ratings continued that the ratings continue to be supported by high GDP per capita, as well as improving policy predictability. The ratings remain constrained by very high external financing needs (including a large current account deficit), high – albeit declining – external debt, as well as the significant debt overhang in the private sector and the slow pace of resolving the non-performing assets that were transferred outside the banking sector. Moderate institutional weaknesses and persisting geopolitical risk factors also continue to weigh on the ratings.

Despite persistent external adversities, economic growth remains positive, albeit moderating. Real GDP grew by 2.8% in H1 23, compared to 5.5% in H1 22, reflecting the ongoing recovery in the economy’s main sectors (including tourism, transportation, and information technology). Tourism continued to grow strongly in the first eight months of 2023, with tourist arrivals increasing by 24.5% to 2.65 million, compared to 2.1 million during the same period of 2022.

CI expects real GDP to ease to 2.5% in 2023, before increasing to 2.8% in 2024, the company said.

"This is based on our expectation that external adversities will persist throughout the forecast horizon, with high hydrocarbon prices and tighter monetary policy in the eurozone weighing on both domestic and external demand. Nevertheless, economic growth will continue to benefit from investment in numerous economic activities supported by RRF funding and foreign private capital inflows. The authorities are expected to have received EUR255mn from the RRF in 2022, with the disbursement of the remainder conditional on the implementation of structural reforms that target the public, energy, legal and digital sectors over the next five years," it elaborated.

The public finances continued to improve in the first seven months of 2023, with the general government budget posting an overall surplus (on a cash basis) of 1.5% of GDP, and a primary surplus of 2.3%. Going forward, CI expects the overall general government budget position to remain in surplus, averaging 1.7% of GDP in 2023-25. This is lower than our previous projection of 1.9% of GDP due to higher than expected spending on public sector wages and defence throughout the forecast horizon. Reflecting the improvement in the budget position, general government debt declined significantly to a still high 82.0% of GDP in H1 23, and is on course to decrease further to 80.2% by year end.

Risks to the fiscal outlook persist and outcomes could be weaker than envisaged if fiscal discipline declines or spending on subsidies, social welfare, and public sector wages is increased in an effort to lessen the impact of rising inflation. Other risks to the budget stem from the increasing cost of the national health system (GESY) and a potential decline in tax revenues if downside risks to GDP growth materialise. At present, CI considers the impact of higher risk premia and tighter eurozone monetary policy on the public finances to be manageable due to the decline in general government debt and the fact that 70% of the debt stock bears a fixed interest rate.

Also according to CI Ratings, short-term refinancing risks currently appear manageable and have remained stable since our last review. This is due to the government’s sound fiscal management, favourable debt maturity structure and timely access to capital markets, as well as the prudent building of cash buffers that cover 100% of gross financing needs for at least the next 12 months. CI notes that investor sentiment towards Cypriot government debt has remained positive despite the progressive tightening of monetary policy in the eurozone and the gradual reduction of asset purchasing programmes. This is evidenced by the results of the government’s latest 10-year EUR1bn sustainable bond issue, which was 12 times oversubscribed. The bond attracted a diversified range of private investors, banks and hedge funds, mainly from Europe and the United Kingdom.

In CI’s view, debt maturities – which are estimated at EUR0.4bn (1.3% of GDP) for the last quarter of 2023 and EUR2.4bn (7.6% of GDP) for 2024 – are within the repayment capacity of the government and do not pose any refinancing challenges at present.

External strength is moderately weak, reflecting a large current account deficit and very high external debt. The current account deficit increased to 6.5% of GDP in Q1 23 (2.6% in Q1 22), while external debt (excluding SPEs) declined to 366.7% of GDP in March 2023, from 391.7% in December 2022.

Banking sector strength remains moderate despite ongoing efforts to improve bank balance sheets. The aggregate non-performing loan (NPL) ratio declined further to 9.0% of total loans in April 2023 (from 9.5% in December 2022), while accumulated provisions increased to 49.4% from 47.5% over the same period, but remain below prudential coverage levels. Asset quality is affected by the debt overhang in the household and corporate sectors, which stood at a still high 218% of GDP in March 2023 (down from 248% a year earlier). CI notes that the elevated level of private debt as well as tighter financial conditions and declining private financial assets could lead to the formation of new NPLs, particularly if economic conditions deteriorate. Sector capital adequacy is currently satisfactory however, with an average CET-1 ratio of 19.7% at end-December 2022.

Rating Outlook

The Stable Outlook indicates that the ratings are unlikely to change in the next 12 months, and balances the risks stemming from a potential economic slowdown in the eurozone and prolonged periods of high energy and food prices against the sovereign’s improving shock absorption capacity and resilient economic and fiscal performance.

Rating Outlook: Upside Scenario

The Outlook could be revised to Positive in the next 12 months if the improvement in macroeconomic and fiscal fundamentals, including debt reduction, proves durable. The ratings could be upgraded should the government implement comprehensive structural reforms that would see faster resolution of transferred NPLs and improved revenue mobilisation. Moreover, there could be upward pressure on the ratings if banks increase their efforts to improve asset quality and loan coverage.

Rating Outlook: Downside Scenario

Conversely, the Outlook could be revised to Negative in the next 12 months should fiscal performance weaken and public debt dynamics reverse, due for example to a shift in policy direction, a decline in fiscal discipline or significantly weaker economic performance, or if adverse shocks trigger a deterioration in the public and/or external finances.