Capital Intelligence raises Cyprus sovereign ratings

Capital Intelligence, the international rating agency, has raised the long-term foreign currency rating of the Republic of Cyprus to ‘A+’ from ‘A’ and affirmed its short-term foreign currency rating of ‘A1’. The outlook on the ratings remains ‘stable’.

The ratings upgrade is driven by the strong structural improvement in the public finances over the past few years, which has put government debt on a firmly downward trajectory, and also reflects Cyprus’ upcoming accession to the euro area, which will shield the economy from balance of payments pressures and diminish the risk of a currency crisis.

The general government budget has over-performed again this year and is expected to record a small surplus rather than a deficit of 1.6% of GDP as initially planned. The draft 2008 budget envisions a shortfall of just 0.5% of GDP and the government intends to keep the deficit at low levels in 2009 and 2010.

As a proportion of GDP, government debt has fallen from 70.2% in 2004 to about 60.5% in 2007. CI expects the debt ratio to approach a still reasonably high 50% by the end of 2009, pushed down by the combination of small primary budget surpluses (ie excluding interest expenditure), robust GDP growth and the repayment of debt using sinking fund deposits.

Although there is some uncertainty about the fiscal outlook given the possibility of policy changes following presidential elections in February 2008, CI would expect the next government to continue to adhere to the EU stability and growth pact and to remain committed to reducing the public debt burden.

Cyprus’ participation in the euro area will largely insulate it from external financial risks, but the loss of national monetary policy will make it even more imperative that the government retains sufficient fiscal flexibility to be able to support activity during downswings in the business cycle and pursues structural policies geared to increasing the resilience and adaptability of the country’s small and moderately diversified economy to unanticipated shocks and demand shifts.

Recent growth performance has been good, with the economy expanding by around 4% in each of the past four years (2004-2007) and GDP per head reaching about 90% of the average for the EU25 member states. However, productivity growth in Cyprus has generally been slower than in the euro area and there are some lingering concerns about the competitiveness of the economy. Cyprus also faces longer-term economic and fiscal challenges associated with an ageing population and comparatively generous pension system.

Cyprus’ ratings are likely to improve further if the authorities press ahead with structural reforms while maintaining fiscal discipline. Economic development and fiscal reform plans are broadly appropriate and include initiatives to upgrade tourism and promote other internationally tradable service sectors, enhance labour and product market flexibility, improve education and training, and encourage innovation and technology diffusion. On the fiscal front, the government is strengthening the institutional framework for budgetary policy and is considering parametric changes to the social security system.

However, while progress is being made, implementation has been slow and uneven and there is not yet a board-based consensus on how best to reform the large public sector or pension system.