Fitch Upgrades Cyprus’ Long-Term Foreign-Currency to ‘BB’

25 October 2017


Fitch Ratings has upgraded Cyprus’ Long-Term Foreign-Currency Issuer Default Rating (IDR) to `BB` from `BB-‘with a positive outlook.

The upgrade of Cyprus’ IDRs reflects the following key rating drivers and their relative weights, Fitch says in an official report.

Cyprus is experiencing a strong improvement in the performance of and outlook for its public finances. The budget is on track to record a surplus of 1% of GDP in 2017, after 0.4% in 2016, compared with the `BB` median of a 3.2% deficit. Gross general government debt (GGGD) is forecast to fall just below 100% of GDP in 2017 from 108% at end-2016, owing to strong nominal GDP growth, the budget surplus and a one-off effect from early debt repayment. Medium-term debt dynamics point to a firmly declining trend. Our baseline medium-term assumptions of 2% GDP growth and gradually increasing effective interest rates would lead GGGD to decline to around 80% in 2022, an average 4pp decline annually.

The economic recovery has broadened and GDP growth has consistently outperformed forecasts over recent years, the Cyprus News Agency reports. Fitch now forecasts an average 3.5% GDP growth in 2017 and 2018, in light of the broad-based recovery in 1H17 (3.6%) and improving confidence indicators, compared with around 2.5% a year ago when Cyprus was upgraded to `BB-`. The recovery is also reflected in the labour market, where unemployment rate has declined to 10.6% in 2Q17 from a post-crisis peak of 16% in 2014.

Nevertheless, medium-term growth potential remains highly uncertain after the global financial crises. Although the strong growth momentum creates a favourable backdrop for the necessary deleveraging of the private sector, faster resolution of mortgage arrears could slow the recovery through weaker household consumption in the short run.

The sovereign is gradually rebuilding its track record of market access: it issued a seven-year bond in June 2017 at a 2.8% yield. Current cash reserves exceed the sovereign`s total 2018 financing needs.

Cyprus’ `BB’ IDRs also reflect the following key rating drivers:

Notwithstanding the cyclical recovery, the banking sector`s exceptionally weak asset quality remains a key weakness for Cyprus`s credit profile and material downside risk to the recovery. The ratio of non-performing exposures (NPEs) to total loans was 44.1% in June 2017, among the highest of Fitch-rated sovereigns, compared with 46.4% in December 2016. The total value of NPEs was EUR22.8 billion, more than 125% of GDP, but down from a peak of EUR28.4 billion in December 2014. Losses on unreserved NPEs could be significant if further haircuts were needed to liquidate underlying collateral, highlighting the potential need for further capitalisation. In such a scenario, it is unclear if that would come from the private or public sector.

Deleveraging is progressing slowly, despite the improved repayment capacity of the private sector and banks` focus on NPE resolution. The persistently high level of NPEs constraints new lending capacity and poses a significant downside risk to the recovery. The three largest banks (Bank of Cyprus, Hellenic Bank and Cyprus Coop Bank) have had ambitious and detailed strategies since 2015, including debt-to-equity swaps, restructuring and establishment of servicing platforms but the resolution of NPEs remains slow and moral hazard risks high.

Deposits in the banking sector were EUR49.1 billion in August 2017, little changed since December 2016, but liquidity conditions have improved, reflected for example in the full repayment of ECB emergency liquidity assistance balance earlier this year. However, the sector`s liquidity remains sensitive to changes in market sentiment.

Cyprus`s ratings are supported by high GDP per capita, a skilled labour force, and strong governance indicators relative to `BB` peers.

The country`s current account deficit widened to 4.9% of GDP in 2016 from 1.5% a year earlier, the Cyprus News Agency says. The data is distorted by special purpose entities (SPEs, mainly the non-resident shipping industry). The current account deficit would have been significantly lower excluding SPEs, according to central bank estimates. For 2017 and 2018 Fitch forecasts deficit (including SPEs) to remain close to 5%, due to a pick-up in domestic demand, including investment with high import elasticity.

Net external debt (NXD) was 150% of GDP at end-2016, compared with the `BB` median of 19%. Cyprus`s international investment position (IIP) was -128% of GDP, the second-highest indebtedness among eurozone members, almost 4x the EU`s Macro Imbalance Procedure threshold of -35%.

Fitch`s proprietary SRM assigns a score equivalent to a rating of `BBB+` on the Long-Term Foreign-Currency (LT FC) IDR scale.

Fitch`s sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:
– External finances: -2 notches, to reflect the very high net external debt relative to peers (not captured in the model) and not fully benefiting from the euro`s reserve currency status (assigned by the model)
– Structural features: -2 notches, to reflect the banking sector weakness that could pose a large contingent liability to the sovereign and lead to macro-stability risks.

Fitch`s SRM is the agency`s proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch`s QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

Future developments that may, individually or collectively, lead to an upgrade include:
-Reduction of private sector indebtedness and banking sector NPEs that materially reduce the sovereign`s contingent liabilities;
-Track record of declining GGGD/GDP ratio; and
-Narrowing current account deficit and reduction in external indebtedness.

The Outlook is Positive. Consequently Fitch does not currently anticipate developments with a high likelihood of leading to a downgrade. However, future developments that may individually or collectively lead to negative rating action include:
-Failure to improve asset quality in the banking sector; and
-Deterioration of budget balances or materialisation of contingent liabilities that results in the stalling of the decline in the government debt-to-GDP ratio.

Fitch does not expect substantial progress with reunification talks between the Greek and Turkish Cypriots over the next quarters. The reunification would bring economic benefits to both sides in the long term but would entail short-term costs and uncertainties.

Gross government debt-reducing operations such as future privatisations are not considered in Fitch`s baseline scenario. The projections also do not include the impact of potential future gas reserves off the Southern shores of Cyprus, the benefits from which are several years into the future.

The full list of rating actions is as follows:
–Long-Term Foreign- and Local-Currency IDRs upgraded to `BB` from `BB-`; Outlook Positive;
–Short-Term Foreign- and Local-Currency IDRs affirmed at `B`;
–Country Ceiling upgraded to `BBB` from `BBB-`;
–Issue ratings on long-term senior unsecured – local-currency bonds upgraded to `BB` from `BB-`;


Source: Gold News