Fitch Ratings has downgraded the Republic of Cyprus's Long-term foreign and local currency Issuer Default Rating (IDRs) to 'BB+' from 'BBB-'. The Short-term IDR has also been downgraded to 'B' from 'F3'. The Outlook on the Long-term IDRs is Negative. Fitch has simultaneously affirmed the eurozone Country Ceiling
for Cyprus at 'AAA'.
The downgrade reflects a material increase in the amount of capital Fitch assumes the Cypriot banks will require compared to its previous estimate at the time of the last formal review of Cyprus's sovereign ratings in January 2012. This is principally due to Greek corporate and households exposures of the largest three banks, Bank of Cyprus, Cyprus Popular Bank (CPB) and Hellenic Bank and to a lesser degree the expected deterioration in their domestic asset quality.
BANKING SECTOR SUPPORT
In addition to the EUR1.8bn (10% of GDP) required for Cyprus Popular Bank
('BB+'/Rating Watch Negative), Fitch assesses that Cypriot banks will
require further substantial injections of capital, potentially up to
EUR4bn (23% of GDP). While most of the increase in losses is associated
with Cypriot banks' Greek exposure, the reported non-performing loan ratio
for domestic Cypriot loans has also risen notably over the past year as
the Cypriot economy has contracted and unemployment has risen. Even
assuming that Greece remains in the eurozone, Cypriot banks will have to
bear significant further loan losses as the Greek economy continues to
contract over the medium term as well as the deterioration in domestic
asset quality.
Fitch acknowledges that its estimates of the losses and capital needs of
Cypriot banks are subject to considerable uncertainty and are
conservative. Nonetheless, in Fitch's opinion, Cypriot banks will require
substantial injections of capital in order to secure confidence in their
financial viability. Fitch judges that the scope for further
capital-raising from the private sector is limited and thus assumes that
the capital will have to be provided by the government. With the fiscal
cost of bank support potentially as high as EUR6bn, general government
debt is likely to exceed 100% of GDP compared to the agency's previous
forecast of 88%.
FISCAL PERFORMANCE AND FINANCING
The budget has underperformed government expectations in the first half of
2012. Though corrective measures are likely to be introduced, the official
deficit/GDP target of 3% is likely to be missed and is forecast by Fitch
to reach 3.9% of GDP. Nonetheless, the fiscal adjustment necessary to
stabilise the government debt to GDP ratio is moderate relative to several
European peers. That said, significant fiscal reform will be required to
absorb the economic and financial costs of an aging population and as part
of a broader structural reform effort necessary to enhance productivity
and international competitiveness,
Fitch judges the near-term liquidity risk faced by the sovereign to be
low. Bond maturities are moderate in 2012 and 2013 and fiscal financing is
secure for the remainder of 2012. In 2013 the government has EUR2.25bn of
refinancing needs, including a EUR1.5bn EMTN redemption in July 2013.
Fitch expects Cyprus to secure a bilateral loan, likely from the Russian
Federation ('BBB'/Stable), which will be sufficient to cover the gross
budgetary funding requirement up to end-2013. However, the agency also
expects that Cyprus will have to secure a loan from the EFSF/ESM to fund
the broader recapitalisation of the banking sector.
The near to medium-term economic outlook for Cyprus is weak. Fitch expects
the economy to stagnate this year and next and thereafter to recover only
slowly as macroeconomic imbalances unwind and the headwinds from the
on-going eurozone and Greek crises persist.
NEGATIVE OUTLOOK
The Outlook on Cyprus remains Negative, indicating a heightened risk of
further downgrades. The Negative Outlook primarily reflects the risks
associated with a further worsening of the eurozone crisis, notably
further contagion from Greece.
In the event of a Greek exit from the eurozone, Fitch would review
Cyprus's sovereign ratings. In such a stress scenario, Fitch's preliminary
estimates are that Cypriot banks could require significantly more capital
than currently incorporated into Cyprus's 'BB+' sovereign ratings.
