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DBRS upgrades Cyprus

06/06/2017 09:35
DBRS Ratings Limited (DBRS) has upgraded the Republic of Cyprus’s long-term foreign and local currency issuer ratings from B to BB (low) and changed the outlook from positive to stable. DBRS also confirmed the short-term foreign and local currency issuer ratings at R-4 and maintained the stable outlook.

According to a statement, the upgrade is driven by Cyprus’s strong fiscal results over the past two years and declining imbalances in the private sector. The headline deficit has shifted to surplus and the primary fiscal surplus has increased. Fiscal reforms adopted in recent years should help maintain a sound budget positon. At the same time, both household and non-financial corporate debt have declined and there has been progress in the resolution of non-performing loans. The improvements in the “Fiscal Management and Policy” and the “Monetary Policy and Financial Stability” sections of our analysis were the key factors for the rating upgrade.

The stable outlook on the ratings is a reflection of the substantial challenges still ahead, despite the economic recovery. While falling from their peaks, non-performing loans remain very high, weighing on the performance of the banking sector. Private sector debt, although trending downwards, is still high as is public sector debt.

The ratings reflect Cyprus’s solid fiscal performance in recent years. The government achieved a quick adjustment in the budget position, with the headline deficit shifting from 5.7% of GDP in 2011 to a surplus of 0.4% in 2016. The primary surplus reached 3% and is expected to remain around this level over the coming years. Fiscal management has also been strengthened, through the adoption of reforms and the Fiscal Responsibility and Budget Law, which aims at maintaining revenue and expenditure ceilings and includes procedures to monitor fiscal risks. The public debt maturity structure is also favourable and provides further support to the ratings. The government has benefited from lower interest rates and extended debt maturities, thus reducing refinancing risks.

Strengthened institutions, together with a favourable corporate tax environment, support the attractiveness of Cyprus as a business services centre. Although its advantage could be eroded by external competitors or taxation changes, DBRS expects the business services sector to remain an important source of employment and income for the economy. Cyprus has also taken advantage of its geographic location that makes it an attractive tourist destination. The tourism sector has expanded to new markets in recent years, increasing its resilience.

Cyprus also benefits significantly from its membership in the Eurozone. Policy measures implemented by Cyprus since its EU accession in 2004 and adoption of the Euro in 2008, and more recently, under the three-year EU/IMF economic adjustment programme, have helped strengthen domestic institutions. The programme, which concluded in March 2016, allowed Cyprus to consolidate its public finances and restructure its banking sector. EU membership has thus ensured financial support, while EU budget transfers and long-term infrastructure financing from the European Investment Bank (EIB) contribute to investment.

Nevertheless, the ratings underline Cyprus’s significant credit challenges. Cypriot banks’ non-performing loans (NPLs) are extremely high, at 46.3% of total loans. Taking into account only the 90-days past due loans, the NPL ratio is 34.7%. Nevertheless, the stock of NPLs has fallen by 17% from their peak in February 2015, and important efforts are being taken to speed the resolution of NPLs. Restructured loans increased in 2016, supported by the insolvency framework and the banks’ restructuring units. The comprehensive framework also includes the legislation to accelerate the transfer of title deeds and the legislation to allow banks to sell loans to third parties. These measures to tackle NPLs, together with growth and a recovery of the property market, are likely to support the improvement in bank asset quality.

Private sector debt also remains at high levels. This suggests that deleveraging could continue to weigh on investment and consumption, and that households and non-financial corporations are vulnerable to sharp rises in interest rates. Likewise, general government debt is high at 107.8% of GDP. Although the debt ratio is estimated to have peaked and the fiscal adjustment is complete at this stage, continued fiscal surpluses and sustained solid economic growth will be essential to bring public debt down.

On the external front, although the current account deficit has shrunk, the deficit and the net external liability position, leave Cyprus exposed to shocks. These imbalances reflect in part activities in the international business centre and special purpose entities operating in the shipping sector, with limited links to the domestic economy. Cyprus’s small, service-driven economy is also exposed to adverse changes in external demand. Although tourism benefits from a market of wealthy economies, a severe downturn in Europe could dampen growth in the sector.

Upward rating action will depend on Cyprus’s ability to sustain economic growth over the medium term. The continued recovery of the economy and the sustainability of the fiscal adjustment should firmly place public debt dynamics on a downward trajectory. A material reduction of non-performing loans or strong progress on privatisations that leads to a faster-than-expected decline in public debt, could also put upward pressure on the ratings. However, if a prolonged period of significantly weak growth were to materialise, combined with large fiscal imbalances and higher financing needs, this could result in downward pressure on the ratings.