Fitch affirms Cyprus at ‘AA-‘; Outlook stable

Fitch Ratings affirmed the Republic of  Cyprus’s Long-term foreign currency Issuer Default rating (IDR) at ‘AA-‘ (AA minus) with a Stable Outlook and Short-term foreign currency rating at ‘F1+’. The agency also affirmed the local currency IDR at ‘AA-‘ (AA minus) with a Stable Outlook and the Country Ceiling at ‘AAA’.
“Membership of the euro area – which renders transfer and convertibility risk negligible – and fiscal improvements over the last five years have helped Cyprus achieve its current ratings,” says Chris Pryce, a Director in Fitch’s Sovereign
team. The country formally joined the union on 1 January 2008.
Cyprus is a modern, predominantly services-based economy. It has a significant
tourist industry, a growing business services sector and a long-established capitalist economy. Its income per head compares reasonably well with its rated peers. Economic growth has been robust, averaging around 3.6% over the past decade and inflation has been contained. The balance of payments current account deficit is around 6% but it is quite well-covered by foreign direct investment.
As a member of the EMU, Cyprus’s fiscal performance and economic flexibility to
respond to shocks are more important as a driver of sovereign ratings than its external finances. In 2007 the Republic recorded its first overall government surplus in several decades and public debt fell to 60% of GDP (2006: 65.2%) by the end of the year. Surpluses, albeit smaller one, are expected this year and next, and the country’s debt ratio is expected to fall sharply to below 50% of GDP by end-2008, thanks largely to the use of financial assets (totalling about 6% of GDP at end-2007) to pay down debt in 2008. There are, however, two big uncertainties.
“It still has to confront one of the largest threats to long-term fiscal stability from an ageing population in Europe as well as the continuing political division of the island,” says Pryce. The banking sector is also  relatively weak in comparison to sovereigns in the ‘AA’ category although there  have been improvements with the Fitch Bank System Indicator (BSI) rising to ‘C’  (adequate) from ‘D’ (weak) in 2007 to reflect an upward revision to the rating  of a major bank.
The election of a new president, Demetris Christofias, seems likely to break the   logjam in negotiations between the Greek Cypriot and Turkish Cypriot communities
associated with his hard-line predecessor, Tassos Papadopoulos. Broad-based political support for resumption of talks now seems to exist and negotiations could begin in months under the auspices of the UN. While any final resolution is a distant prospect, re-unification would have sizeable economic benefits although there would also be a short-term fiscal cost.
While population ageing and its impact on public expenditure was not the subject of open debate in the recent election, Fitch understands that extensive discussions have taken place among the social partners (primarily trade unions, employers and the government) last year and an element of agreement on proposed reforms exists. The government’s Stability Programme presented to the EU in December 2007 assumed that there will be phased increases of 1.3% every five years in social security contributions until 2037 as well as stricter eligibility criteria for pensions. There has apparently been no agreement on proposals to lift the retirement age to 65 or to reduce benefit levels. If the agreed reforms are implemented, the fiscal threat will be reduced at least in the shorter term but the long-term problems will remain and
become a more significant adverse factor in the Republic’s credit position. Implementation of deep-seated pension reforms will be necessary in order to
prevent ageing pressures becoming a more significant adverse factor in the Republic’s credit position in the longer term. Cyprus’s ratings were upgraded in July 2007 when the republic was approved for membership of the EMU.