Moody's Investors Service has upgraded the Cyprus government bond rating to B3 from Caa3 and the outlook to ‘stable’ from ‘positive’ on progress in addressing the country's key challenges with respect to macroeconomic stability, fiscal consolidation and banking sector stability.
Moody's believes that Cyprus remains in a similar position to other defaulted sovereigns. The underlying problems that led to the country's initial default are not yet fully resolved and the likelihood of redefault will remain elevated for a sustained period of time, with no forecast of a substantial economic recovery before 2016.
The rating agency said that the upgrade reflects two key drivers:
1) The consolidation of the government's fiscal position, as illustrated by an expected return to a primary budget surplus from 2014, and the expectation that public debt relative to GDP will level off in 2015.
2) The stabilisation of Cyprus's financial sector through the recapitalisation of troubled banks, which, to some extent, lowers the risk that bank-related contingent liabilities will crystallise on the government's balance sheet.
Of the four systemic banks submitted to a stress test on capital adequacy by the European Central bank last month, Bank of Cyprus recently raised EUR 1 bln is fresh capital from local and overseas investors, the state pumped EUR 1.5 bln in the Cooperative banking sector and the privately held RCB Bank (formerly Russian Commercial Bank Cyprus) has twice the required level of capital.
Second biggest lender Hellenic Bank, that raised some EUR 100 mln and attracted new investors at the beginning of the year, is undergoing a second capital increase of about EUR 200 mln that will more than cover the shortfall identified by the ECB in the stress test based on 2013 data.
However, Moody’s warned in its latest upgrade that the Cyprus government bond rating remains constrained by substantial credit challenges, including a weak economic outlook and the very high and still rising non-performing loans (NPLs) in the banking sector, which generate further negative risks to the government's balance sheet.
Concurrently, Moody's on Friday raised the bond ceilings to B1/NP from Caa1/NP, and the deposit ceiling to Caa1/NP from Caa2/NP. In both cases the rise is in line with the change in the government bond rating.
Supporting the rating upgrade, Moody’s said Cyprus's fiscal metrics have exceeded the targets set with the Troika of international lenders (EU, IMF and ECB): In 2013, the primary deficit fell to 2.0% of GDP versus its target of 4.2% in the original economic adjustment programme. Most of the measures aimed at permanently reducing the deficit were included in the 2013 budget, and resulted in significant fiscal consolidation of 7.5% percentage points of GDP over 2013-14, according to IMF data.
“The fact that the economic contraction in 2013 and 2014 was not as severe as initially expected under the programme also contributed to the government's ability to outperform fiscal targets,” the rating agency said.
“In Moody's view, the economic and fiscal outperformance increases the likelihood of the government achieving the rest of its medium-term fiscal consolidation targets, e.g. reaching a primary surplus of 4% of GDP in 2018, and thereby succeeding in its objective of putting debt on a more sustainable path.”
Moody's also estimates that the Cypriot government's fiscal deficit will likely come down to around 3% of GDP in 2014, from 4.9% in 2013 and 5.8% in 2012, and that the primary balance will improve by 2 percentage points in 2014, generating about 0.1% of GDP in surplus. This estimate assumes a contraction of the economy in 2014 by 2.5% in real terms and tight budget execution through 2014 on both expenditures and revenues. It also takes into account the impact of the fiscal measures enacted in 2013, including an increase in the corporate tax rate to 12.5% from 10% and the near-doubling of the withholding tax on interest to 30%, as well as the rationalisation of expenditures.
Comparing the budgeted revenue with the collected one, the government's budget forecasting has proven prudent, says Moody's. For instance, in the government's budget for 2015, revenue (net of borrowing) for 2014 has been revised up by 5.6% compared with budgeted levels, with direct and indirect taxes having been revised up by 2.6%.
Under the rating agency's baseline scenario, “assuming a modest and gradual economic recovery from 2015-16 with growth progressively rising to around 2% over the medium term, government debt is expected to peak at around 110% of GDP in 2015, before slowly reversing. Under such scenario, we assume that the EUR 1 bln loan-to-assets swap that the Ministry of Finance intends to complete with the Central Bank will proceed.”
The second driver for the Moody’s upgrade is the improvement in the stability of the financial sector with the banks' balance sheets bolstered through increased capital buffers, external deleveraging (through sales of non-core activities overseas) and improvements in their funding profiles. As a consequence, the sovereign's susceptibility to shocks emanating from the banking sector has decreased to some extent.
The rating agency also notes that the authorities have strengthened the regulatory and supervisory framework, in particular by implementing measures intended to aid banks in dealing with their high NPLs, for instance through the reform of loan foreclosure procedures as set out in a law enacted on 6 September and that was recently enforced by the Supreme Court of Cyprus as it ruled out amendments aimed at diminishing this law.
Looking ahead, Moody’s said upward pressure to Cyprus's government bond rating could result from further fiscal progress under the Troika programme, e.g. if the government's primary surplus were to exceed targets and reach 4% earlier than planned (i.e. before 2018). In addition, evidence that the risks to growth and to the banking sector are unlikely to crystallise would imply upward pressure: higher economic growth and/or a more rapid reversal in the upward trend for banks' NPLs would be credit positive.
Conversely, downward pressure could emerge if the government's commitment to meeting the Troika programme's conditionality and restoring macro-financial stability were to weaken, in particular if the expected low resumption of growth fails to materialise.
