Fitch Upgrades Cypriot Economy
Fitch Ratings has upgraded Cyprus’s Long-term foreign and local currency Issue Default Ratings (IDRs) by one notch to ‘BB-‘ from ‘B+’. The issue ratings on Cyprus’s senior unsecured foreign and local-currency bonds have also been upgraded to ‘BB-‘ from ‘B+’. The Outlooks on the long-term IDRs are Positive. The Country Ceiling has been upgraded to ‘BBB-‘ from ‘BB+’ and the short-term foreign and local currency IDRs have been affirmed at ‘B’.
According to Fitch press release, Cyprus is continuing to make strong progress in its adjustment following the 2013 banking crisis. Its exit from the EU and IMF programme in March took place in a context of outperformance of fiscal and economic programme targets, success at lifting capital controls, and steps taken to restructure the banking sector.
The economic recovery, now into its second year, is supporting employment, bank asset quality adjustment, and public finances. Fitch is projecting GDP growth of 2.9% in 2016 (from 1.9% projected a year earlier). A strong 1H16 outturn was supported by private consumption and investment, and reflected broad based growth across industries, most notably in tourism. Unemployment reached 12.1% in 2Q16, from 14.9% in 2015. For 2017-2018, GDP growth of around 2.5% will benefit from an expected increase in foreign direct investment. Downside risks to the outlook stem from banking sector deleveraging and the weak external environment.
The banking sector is gradually strengthening, evident in the pick-up in deposits and stable capitalisation. Deleveraging is ongoing, with overall sector assets down to 3.7x GDP in June 2016 from almost 6x in 2009. The Bank of Cyprus (placed into resolution in 2013 and recapitalised partly through a bail-in of depositors) has reduced its reliance on emergency liquidity assistance, to EUR1.5bn by August 2016 from over EUR11bn in April 2013. The property sector remains illiquid but prices seem to be stabilising at around 30% below their 2008 peak.
Strengthened supervision, management and regulations are helping to slowly reduce the exceptionally large stock of non-performing exposures (NPEs) at 48% of total loans. The new foreclosure framework is in the initial phases of implementation. The stock of NPEs has declined slightly to EUR25bn as of August 2016 from EUR28.4bn a year earlier. The volume of new restructurings is also increasing, albeit from a low level. In April 2016, Fitch upgraded the IDRs of Bank of Cyprus (48% share of gross lending) to ‘B-‘ from ‘CCC’ and Hellenic Bank to ‘B’ from ‘B-‘, with stable outlooks for the two banks.
A strong track record of fiscal policy management provides confidence that authorities will remain committed to government debt reduction in line with fiscal targets. The budget is close to balance, although the 2017 budget includes tax relief measures that will widen the deficit, based on government projections, to 0.6% of GDP in 2017 from 0.3% in 2016 (vs. modest surpluses previously projected). Fitch projects government debt to decline to just over 100% of GDP by 2018 (still more than twice the projected ‘BB’ peer median) from a peak of 108.9% in 2015.
The financing position and outlook are favourable. Debt financing operations have contributed to the government’s cash position, expected by authorities at end 2016 to exceed financing needs until 2017. Cyprus’s first post-programme market issuance in July (representing the fourth issuance since entering the bailout programme in 2013) was priced at the lowest coupon rate achieved by Cyprus for a euro benchmark bond. The seven-year 3.75% EUR1bn bond was realised without support from the European Central Bank’s bond-buying scheme.
Fitch that Cyprus’ ‘BB-‘ IDRs also reflect the following key rating drivers:
Banks remain fundamentally weak and pose an ongoing risk to economic stability. Despite a fall in the stock of NPEs, the ratio of NPEs to total loans stood at 48% in August 2016, still the highest of all Fitch-rated sovereigns and up from 45% at end-2015. Excluding overseas branches and subsidiaries, the ratio is even higher, at 57%. With provisioning coverage of NPEs at 38.5%, unreserved problem loans, represented by gross NPEs minus system-wide reserves, stood at EUR15.4bn (87% of GDP) from EUR16.8bn (97% of GDP) at end 2015.
Net external debt (NXD) is exceptionally high at 139% of GDP at end-2015 compared with the ‘BB’ range median of 16%, reflecting a highly indebted private as well as public sector. The NXD figure has been revised up by over 70 percentage points of GDP following the shift of external statistics compilation to the BPM6 framework in June 2014, owing to the inclusion of capital-intensive ship-owners as Cypriot economic units irrespective of the location of their activities.
Cyprus is still running a sizeable current account deficit, which implies that further economic rebalancing may be required over the medium term. It was 3.7% of GDP in 2015, albeit down from over 15% in 2008. Fitch has revised up its current account deficit projections to around 4.3% of GDP for the period of 2016-2018, reflecting an increase in consumption led imports registered in 1H16 and expected to continue in the forecast period.
Negotiations for a deal between Greek and Turkish Cypriots to reunify the island are underway. The likelihood of success and the terms of a potential deal remain uncertain. A deal would benefit both sides in the long term by boosting the economy, but would entail short-term costs and uncertainties.
Focus on reaching an agreement could divert political capital away from structural reform implementation, where progress to-date has been mixed. The improved economy and exit from bailout programme could reduce the urgency for reform. Additionally, municipal elections in December, and presidential elections in 2018, could further delay progress in politically sensitive areas, including public administration reform and the telecom company privatisation.
Fitch judges the impact of Brexit on Cyprus, which is most directly exposed to the UK through tourism (39% share of arrivals), to be moderated by positive developments in the sector including diversification into other markets and the extension of the tourism season. Advance bookings from the UK suggest no slowdown for 2017.
Cyprus’s rating is supported by a high level of GDP per capita, strong governance indicators and a favourable business climate relative to BB range peers.