14/11/2022 06:00
Cypriot banks have not yet fully completed their legacy asset quality clean-up, says S&P Global Ratings, sovereign analyst, Sebastien Boreux.
In an interview with StockWatch, he notes that although the reduction has been very material in recent years, its NPL ratio is still one of the highest in Europe.
"We expect further deterioration should be manageable," he says.
As for system-wide deleveraging, he estimates that “is close to the end, since the bulk of problematic loans have been offloaded from banks’ balance sheets”.
However, the agency does not expect a material growth in loan volumes over the next 12-18 months.
According to the agency’s economist, one key challenge for Cypriot banks will be to sustainably improve their profitability
In particular, he points out, continued reducing system overcapacity and investing in digital transformation will pressure profitability.
Regarding the economy, he points out that the GDP will strengthen by 4.5% in 2022, despite the relatively strong ties of the Cypriot economy with Russia, especially in the tourism and business services sectors, which represent about 14% and 11 % of Cypriot GDP, respectively.
On inflation, he notes that it is expected to reduce consumption and investment in the short term, but more importantly it will burden the budget through fiscal measures.
However, he points out, “while still high, it has been coming down and we expect it will continue to decline through next year in line with global commodity prices”.
In his interview, he also refers to how the disbursement of funds from the EU until 2026 will support investments and economic activity as well as the fronts that the new President of the Republic will have to face in February.
It estimates that the agency could upgrade the ratings on Cyprus or change the outlook from stable to positive if the stability of the financial system were to improve materially, notably via further declines in nonperforming exposure (NPEs) on the banking sector's balance sheet, which could reduce the sector's contingent liability to the government, strengthen the effectiveness of monetary policy transmission, and improve banks' access to debt capital markets.
The interview
In September, the agency upgraded the long-term and short-term credit rating of Cyprus, in foreign and local currency, to "BBB/A-2" from "BBB-/A-3", with a stable outlook. How do you characterize the economic situation in Cyprus amid the pandemic and the Ukrainian crisis?
The recent upgrade of Cyprus’ sovereign ratings reflects the resilience of the Cypriot economy to recent external shocks, including the COVID-19 pandemic and our expectations that the relatively strong economic performance over the last decade will continue once the impact of the war in Ukraine subsides.
This year we expect the economy to expand by 4.5% in spite of Cypriot economy’s relatively strong ties with Russia, notably in the tourism and business services sectors, which account for about 14% and 11% of Cypriot GDP, respectively. Russia also accounts for a large share of overall exports. While the number of Russian tourists has fallen sharply in 2022, after accounting for 27% of total arrivals last year, we expect the sector to perform well this year.
When are you expected to give a positive outlook? On what factors will it depend?
We could raise the sovereign ratings on Cyprus or move the outlook from stable to positive if the stability of the financial system were to improve materially, notably via further declines in nonperforming exposure (NPEs) on the banking sector's balance sheet, which could reduce the sector's contingent liability to the government, strengthen the effectiveness of monetary policy transmission, and improve banks' access to debt capital markets.
The timing of potential rating actions is entirely dependent on economic and financial as well as policy developments in the coming years.
How is Cyprus affected by the energy crisis plaguing Europe? How serious is rising inflation for the economy?
Cyprus is vulnerable to swings in oil prices. Indeed, in addition to the direct impact on households the energy mix in the country consists of 85% of imported oil. Nevertheless, Cyprus does not import gas from Russia and is not exposed to the direct impact of supply disruptions experienced by the rest of Europe.
Inflation is expected to dampen consumption and investment in the short-term, but importantly, it will weigh on the budget via fiscal measures to cushion the impact on the population. However, while still high, it has been coming down and we expect it will continue to decline through next year in line with global commodity prices. In 2023, the sharp slowdown in economic activity in the rest of Europe is expected to slow down growth.
Cyprus is set to receive a large amount of funds in the coming years from EU. Do you think the Recovery Fund will lead to increased investment? How much growth could the NGEU plan add to the economy?
Cyprus is set to receive up to €1.21 billion (5.5% of GDP) by 2026, including €1.06 billion in grants.
Last month, the European Commission endorsed a positive preliminary assessment of Cyprus' payment request for €85 million in grants, submitted in July. The request was based on the achievement of the 14 milestones covering reforms and investments in the electricity market, in the areas of energy efficiency, and anti-corruption and transparency. Measures in the financial sector and public administration, in the domain of digital skills, as well as of Cyprus' audit and control system for the implementation of the RRF are also covered.
We expect the disbursement of these funds through 2026 will support investment and economic activity. According to a paper we published last year , in 2026, Cyprus’s GDP could be cumulatively higher by 3.3% in a low impact scenario and 8.1% in a high impact scenario above where it would have been without the Next Generation EU plan. The two scenarios assume different absorption rates and multiplier effect of public spending.
Furthermore, these estimates do not incorporate second-round effects of higher growth of individual economies through trade channels. Therefore, the results from this perspective, even under the high-impact scenario, may be conservative.
Banks have not clean-up their legacy asset quality
Cypriot banks have turned the page regarding non-performing loans. What are their main challenges?
In our view, Cypriot banks have not yet fully completed their legacy asset quality clean-up. Although the reduction has been very material in recent years, its NPL ratio is still one of the highest in Europe. That said, we expect further deterioration should be manageable. In our view, one key challenge for Cypriot banks will be to sustainably improve their profitability. In particular, continued reducing system overcapacity and investing in digital transformation will pressure profitability.
The size of the Cypriot banking sector has shrunk significantly in recent years. Has it decreased enough, or should it decrease further?
We think that systemwide deleveraging is close to the end, since the bulk of problematic loans have been offloaded from banks’ balance sheets. However, we don´t expect a material growth in loan volumes over the next 12-18 months.
Presidential elections
How do you expect the presidential election process to affect the economy? What are the main fronts that the new President of the Republic will have before him?
Policy shifts are certainly possible in case of a change in administration. However, we don’t expect policy objectives to deviate significantly and therefore the outcome of the next presidential election will in our view not materially impact the economy. Cypriot institutions are relatively strong and policy making has been supported by a culture of consensus building in recent years and we expect it will continue.
In terms of economic policy, the next President is likely going to focus on continuous structural reform implementation, notably related to the green and digital transition, the efficiency of public services and the reinforcement of the health and education system in the context of meeting the RRF’s milestones to be able to receive EU funds.