10/10/2022 09:01
DBRS Ratings GmbH (DBRS Morningstar) confirmed the Republic of Cyprus’ Long-Term Foreign and Local Currency – Issuer Ratings at BBB, according to a statement on Saturday. At the same time, DBRS Morningstar confirmed the Republic of Cyprus’ Short-Term Foreign and Local Currency – Issuer Ratings at R-2 (high). The trend on all ratings remains stable.
DBRS Morningstar says that the stable outlook balances recent favourable fiscal dynamics against important downside risks for the fiscal and economic outlooks.
It notes that fiscal balances have recovered strongly over the past two years. The general government budget deficit narrowed to 1.7% of GDP in 2021 from 5.8% in 2020, driven by a strong economic growth rebound from the COVID-19 shock, which led to a marked increase in tax revenues. Budgetary outcomes have continued to improve over the past months despite the recent energy shock. During the first seven months of 2022, the general government registered a surplus of 0.6% of GDP compared to a deficit of 3.2% of GDP during the same time period in 2021 as still strong economic activity and high inflationary pressures led to a marked increase in nominal tax revenues. In addition, fiscal balances benefitted from a strong decrease in COVID-19 support measures and the so far only moderate fiscal cost of energy support measures.
According to the agency, the most important downside risks are a further escalation of the conflict in Ukraine and high-for-longer energy prices, which might weaken economic activity and require a substantial increase in public support measures. Fiscal pressures might also arise from the National Health System and the planned expansion of the public asset management company KEDIPES. Public debt dynamics currently benefit from high nominal GDP growth and improved fiscal balances. The government’s stability program of April 2022 projects a decrease in the general government debt-to-GDP ratio to an albeit still high 93.9% of GDP at end-2022 from 103.9% of GDP at end-2021. Apart from a potential growth shock, risks for debt dynamics, however, might emanate from a potential materialisation of contingent liabilities related to the still high legacy stock of non-performing loans in the banking system.
It is noted that the BBB ratings are supported by a stable political environment, the government’s sound fiscal and economic policies in recent years, and a favourable government debt profile. Furthermore, although governance indicators have weakened over the past years, DBRS Morningstar continues to view the country’s EU membership as an important anchor for institutional quality. On the other hand, Cyprus also faces significant challenges due to a still high public debt burden and the economy’s comparatively low level of labour productivity. Furthermore, the ratings of Cyprus continue to be constrained by the small size of its service-driven economy, which renders it vulnerable to external shocks.
In terms of the economic growth dynamics, the agency reports that they have remained strong in recent months but outlook is clouded with uncertainty.
It is noted that the Cypriot economy recovered strongly from the COVID-19 shock over the past year, with real GDP expanding by 5.5% in 2021 after contracting by 5.0% in 2020 due to the reopening of the economy and still large public support measures. Growth dynamics remained strong during the first half of 2022 with (seasonally adjusted) real GDP growing by 1.3% and 0.6% on a quarter-on-quarter basis in Q1 2022 and Q2 2022, respectively, driven by rising private consumption notwithstanding a deterioration in consumer sentiment as exemplified by a marked decrease in the European Commission’s Consumer Confidence Indicator for Cyprus following Russia’s invasion of Ukraine and the accompanying increase in inflationary pressures.
Annual inflation in August 2022 reached 9.6%, driven by a spike in energy prices. In addition, economic growth was supported by a strong rebound in non-Russian tourist arrivals. During the first eight months of 2022, the total number of tourists arriving in Cyprus increased by a very large 122% (y-o-y). The most visible impact of the war on the Cypriot economy has so far been a strong decrease in Russian tourist arrivals, which accounted for 19.7% of total arrivals in 2019. The shortfall of Russian tourist arrivals is the main reason why tourism sector activity has so far not caught up to pre-pandemic levels. Despite a strong rebound, total tourist arrivals during the first eight months of 2022 were around 22% below 2019 levels.
In view of still strong growth dynamics in recent months, the Central Bank of Cyprus (CBC) revised in September its real GDP growth forecast for 2022 to 5.5%, up from 2.7% in the June forecast. At the same time, the CBC has decreased its 2023 real GDP growth forecast to 2.5% from 3.6%.
The most important downside risks for the Cypriot economy are a further escalation of the military conflict in Ukraine and high-for-longer energy prices, which could raise economic uncertainty and weaken economic activity. While Cyprus’ energy mix does not rely on gas, it depends heavily on large imports of oil which are utilized both for transportation and electricity generation. Furthermore, a stronger-than-currently-expected monetary tightening by the European Central Bank (ECB) might weaken domestic demand, particularly investment activity.
In contrast, implementation of investments and reforms in Cyprus’s recovery plan could lead to GDP outcomes more favourable than currently envisaged. Cyprus is expected to receive a substantial amount of funds from the Next Generation EU financial instrument (EUR 0.9 billion in grants and EUR 200 million in loans) during 2021-2026, including the EUR 157 million in pre-financing received in 2021. These amounts are in addition to the Multiannual Financial Framework funds of EUR 1.0 billion during 2021-2027.
It is added that the expected exploitation of off-shore gas reserves represents another potential source of growth in the longer term, in general, however, the ratings of Cyprus continue to be constrained by the small size of its service-driven economy, which renders it vulnerable to external shocks. Furthermore, labour productivity levels of the economy remain clearly below the EU average as according to Eurostat, the level of nominal GDP per person employed in Cyprus amounted only to 82.3% of the EU27 average in 2021.
In terms of fiscal data, balances have recovered strongly from the COVID-19 shock. The general government budget deficit narrowed to 1.7% of GDP in 2021 from 5.8% in 2020 as the strong economic growth rebound over the past year led to a marked increase in tax revenues. Total general government revenues rose by a large 17.0% in 2021, driven by higher revenues from VAT and income taxes.
Recent data suggest that budgetary outcomes have continued to improve markedly over the past months. According to interim figures (on a cash basis), the general government registered a surplus of EUR 142 million (0.6% of GDP) during the first seven months of 2022 compared to a deficit of EUR 711 million (3.2% of GDP) during the same time period in 2021, due to an increase in nominal tax revenues and lower COVID-19-related budgetary pressures. The total fiscal cost of COVID-19 support measures is expected to decrease to 0.4% of GDP in 2022 from 3.0% in 2021 and 3.5% in 2020. Budgetary outcomes in 2022 have so far exceeded the government’s fiscal projections in the Stability Programme of April 2022 which forecast a balanced general government budget in 2022 and a surplus of 0.4% of GDP in 2023.T
DBRS Morningstar notes that potential headwinds for public finances might arise from high-for-longer energy prices as they might necessitate additional energy-related support measures beyond 2023. Since late 2021, the government has implemented different measures to cushion the population from high energy prices (e.g. reduction of VAT on household electricity bills and a decrease in excise duties on gasoline) which, however, are largely planned to expire in 2022. The fiscal cost of current measures is estimated at a moderate 0.6 % of GDP in 2022. Furthermore, a potential weakening of economic growth dynamics would likely weigh on tax revenues.
Concerning the high, albeit decreasing, public debt ratio, the agency reports that it continues to be a rating weakness. Public finances have been strongly impacted by the COVID-19 shock but debt dynamics have started to reverse since last year. The COVID-19 shock led to a strong increase in the general government debt-to-GDP ratio to 115.0% of GDP at end-2020 from 91.1% at end-2019, due to a rising budget deficit and a contraction in nominal GDP.
Moreover, DBRS Morningstar notes that the strong increase in gross government debt was partly driven by a strong increase in government cash buffers from 4.1% of GDP at end-2019 to 16.7% at end-2020. Debt dynamics have started to reverse over the past year with general government debt decreasing to an albeit still high 103.9% of GDP at end-2021 due to improving budgetary developments, a rebound in nominal GDP and a partial utilization of the government’s cash buffer.
DBRS Morningstar expects debt dynamics to remain favourable in 2022 due to strong interim budgetary outcomes and a large projected increase in nominal GDP which results both from still strong growth dynamics and a marked increase in the GDP deflator related to high inflationary pressures. The government’s Stability Programme of April 2022 projects general government debt to decrease to 93.9% of GDP at end-2022 and 76.7% at end-2025.
As regards main risks for public finances, they reportedly emanate from a potential economic shock or a materialisation of contingent liabilities related to the still high level of non-performing loan exposures in the banking system. Furthermore, a-larger-than-currently expected ECB monetary policy tightening might raise funding costs of the government, which had decreased markedly over the past years.
The government’s interest burden amounted to a moderate 1.7% of GDP in 2021, down from 3.0% in 2014. In the short-to-medium term, however, risks from rising funding costs are partly mitigated by the government’s still large cash buffer that amounted to 12.9% of GDP in August 2022 and a favourable debt profile, due to the extension of average debt maturities over the past years. The weighted average maturity of government debt stood at 7.7 years in July 2022, up from 4.5 years in December 2012.
The legacy stock of non-performing loans in the banking system from the 2012-2013 crisis remains a credit weakness. Although the NPL ratio has decreased markedly from 46.4% in December 2016 to 11.2% in June 2022, due to sales and write-offs of problem loans, it is still substantially higher than in most other Euro Area economies.
The average NPL ratio for Euro Area economies amounted to 3.2% in March 2022. Furthermore, while the impact of COVID-19 on asset quality metrics has so far been limited due to government support measures and a temporary loan moratorium between April 2020 and June 2021, DBRS Morningstar notes that the stock of Stage 2 loans has increased noticeably following the outbreak of the pandemic. Stage 2 loans accounted for 15% of gross loans in June 2022, up from 9% in December 2019. The increase in Stage 2 loans has been driven by exposures towards non-financial corporates and might indicate rising asset quality risks. This accounts for the negative qualitative adjustment to DBRS Morningstar’s “Monetary Policy and Financial Stability” building block assessment. Moreover, a stronger-than-currently-expected monetary tightening by the ECB might also raise asset quality risks, as a large share of domestic loans have a floating interest rate.
In contrast, financial stability is supported by the banking sector’s strong capitalisation which provides a cushion against some weakening in asset quality and continued weak profitability. The average capital adequacy ratio amounted to a high 20.6% in June 2022. Moreover, the banking sector benefits from a very strong liquidity position due to a high stock of domestic deposits, primarily household deposits. The net stable funding ratio of the banking sector amounted to a high 166% in June 2022.
The ratings take into account the decrease in private sector debt levels in recent years. Households and non-financial corporates have deleveraged significantly in the aftermath of the 2012-2013 crisis. Private non-financial debt (excl. SPEs) decreased to 172% of GDP in March 2022 from 276% in December 2015 and is now on a similar level than in most other Euro Area economies (Average Euro Area in March 2022: 169%). Furthermore, housing prices have increased at a much slower pace than in most other countries. According to Eurostat, housing price in Cyprus rose by 6.6% between March 2015 and March 2022 compared with an average increase of 44.3% for Euro area economies over the same period.
Over the past two years, the economy’s current account balance has been strongly impacted by the opposing effects of a rebound in tourist arrivals and, more recently, the upswing of global oil prices. In 2021, the current account deficit decreased to an albeit still very large 7.2% of GDP from 10.2% in 2020, related to rising service sector exports, especially tourism. Although tourism service exports continued to increase in 2022, this was more than offset by the strong increase in global oil prices, which drove up the economy’s oil import bill for domestic consumption by 137% (y-o-y) during the first half of 2022. Taking into account this deterioration in Cyprus’ terms of trade, the IMF forecasts the current account deficit to widen to 8.2% of GDP in 2022.
In general, external finances are heavily impacted by Cyprus’ role as a financial sector and the operations of special purpose entities (SPEs) which have limited links to the domestic economy. The impact of SPEs is particularly visible with regard to the economy’s negative net international investment position (NIIP) which amounted to a very large 105.5% of GDP in Q2 2022. When excluding external assets and liabilities held by SPEs, the economy’s negative NIIP decreases to 36.8%.
Moreover, DBRS Morningstar notes that the non-SPE economy has undergone a marked external deleveraging over the past years. In terms of net external debt, the non-SPE economy commanded over a net asset position of 32.5% of GDP in Q2 2022 compared to a net debtor position of 22.1% at end 2014. This external deleveraging took place in spite of a substantial widening of the non-SPE current account deficit from 1.4% of GDP in 2017 to 8.3% in 2021. This widening was driven by a large increase in the primary income deficit. The main external financing source of the non-SPE economy over the past years have been inflows of direct investment (primarily equity and real estate). The distortion of the overall NIIP by SPEs underpins a positive qualitive adjustment to the “Balance of Payments” building block.
Going forward, DBRS Morningstar expects the government to implement reforms embedded in Cyprus’s recovery plan, which aims to enhance the efficiency of the judicial system and the public administration, to combat corruption, and to boost the economy’s green and digital transition. The implementation of the plan will depend on the government’s ability to garner sufficient support in parliament to pass legislation. In terms of institutional quality, DBRS Morningstar notes that the country’s ranking in World Governance Indicators (e.g. Control of Corruption, Rule of Law) has deteriorated over the past years and is now below the EU average. At the same time, DBRS Morningstar considers the country’s EU membership as an important anchor for institutional quality. With respect to the reunification talks supported by the United Nations (UN), DBRS Morningstar currently assumes that the chances of a significant breakthrough remain limited.