DBRS: Cyprus confirmed at BBB (low) on fiscal spending worries

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DBRS Morningstar has confirmed the Republic of Cyprus’s long-term foreign and local currency – issuer ratings at BBB (low) and changed the trend to ‘stable’ from ‘positive’, with the short-term foreign and local currency – issuer ratings at R-2 (middle) and the trend also changed to ‘stable’ from ‘positive’.

The rating agency said that the trend change “reflects the fact that the improvements in the public debt trajectory, driven by sustained robust economic growth and large primary surpluses, will no longer be the case in the near term as a result of the global coronavirus disease (COVID-19).

“To deal with the economic fallout, the government has adopted a fiscal support package that will see its fiscal surplus turn into a large deficit and its public debt to rise in 2020. DBRS Morningstar expects the Cypriot economy to eventually recover and the increase in the public debt ratio to reverse, but the timing and pace of the economic recovery are highly uncertain at the moment.”

The BBB (low) ratings are supported by Cyprus’s prudent public debt management framework, its good track record in fiscal deficit reduction, its Eurozone membership fostering sustainable macroeconomic policies, and its openness to investment encouraging a favourable business environment, the rating agency said.

“Nevertheless, Cyprus also faces significant credit challenges related to sizable non-performing exposures (NPEs) in the banking sector and the economy, high levels of private and public sector debt, external imbalances, and the small size of its service-driven economy, which exposes Cyprus to adverse changes in external demand.”

DBRS Morningstar said further progress in substantially reducing banks’ NPEs and private sector debt, and the strengthening of the banking sector would be positive for the ratings.

However, the ratings could be downgraded due to a prolonged period of significantly weak growth, combined with large fiscal imbalances or materialisation of large contingent liabilities. A sharp reversal of the downward trajectory in NPEs could also be negative.

Cyprus’s robust economic performance has been interrupted by the shock from coronavirus. However, the confinement measures, including travel restrictions, imposed in mid-March to limit the spread of the virus in Cyprus and abroad are having a severe impact on economic activity, particularly on the tourism sector. The direct contribution of the tourism sector based on National Accounts data is about 6% of GVA. Including indirect, tourism accounts for about 20% of GDP, according to the European Commission.

Cyprus is facing this crisis from a position of strength, DBRS Morningstar said. Still, after growing robustly over the past five years, with annual real GDP growth averaging 4.4%, the Cypriot economy is forecast to contract sharply. The government forecasts real GDP to fall by 7.0% in 2020, followed by growth of 6.0% in 2021.


High degree of uncertainty


In DBRS Morningstar’s view, the near-term growth outlook is subject to a high degree of uncertainty. It depends on the effectiveness of the policy response and the easing of the lockdown measures in Cyprus and its main tourist markets, including the UK, Russia, the European Union and Israel.

In addition to being a tourist destination, Cyprus is an attractive business services centre and shipping centre, whose performance is also subject to the recovery in external demand. In the longer term, the expected exploitation of off-shore gas reserves represents a potential source of growth.

To support the economy during the current crisis, the government has adopted a package of measures, estimated to have a fiscal impact on the general government accounts of about 4.4% of GDP. The measures include a short-term working scheme to support households’ income, tax relief for businesses and households, postponement of social contributions, and support for the tourism sector. The government is also proposing a loan guarantee scheme and introduced loan repayment moratorium until the end of 2020, with any potential losses to be shared with the banking sector.

Cyprus had the fiscal space to respond to the crisis, but the fiscal support package and lower revenues reflecting the economic recession are set to shift the headline fiscal surplus of 2.7% of GDP in 2019 into a deficit of 4.3% in 2020, according to the government’s Stability Programme.

The large primary surplus of 5.2% in 2019, among the largest in the Euro area, is projected to turn into a 1.8% deficit in 2020. With the fiscal package intended to be temporary, the government projects the headline deficit to fall to a modest 0.4% in 2021.

Higher financing needs and the economic contraction will result in a sharp increase in the government debt ratio in 2020. Government debt fell to 95.5% of GDP in 2019, after an increase in 2018 associated with the sale of Cyprus Cooperative Bank (CCB).

The decline was driven by robust growth, a large primary surplus and early debt repayments, including the Russian loan in September 2019. The government also fully repaid the IMF loan in advance in February 2020. However, the government is forecasting the debt ratio to increase to 116.8% in 2020, before falling again to 103.2% in 2021.