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Morningstar DBRS keeps Cyprus at BBB, ‘stable’ trend

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Morningstar DBRS has confirmed the sovereign ratings for Cyprus, based on strong economic growth, but warned the island remains exposed to geopolitical shocks, and constrained by the small size of the services sector.

The rating agency confirmed the Republic of Cyprus long-term foreign and local currency – issuer ratings at BBB (high), the short-term foreign and local currency – issuer ratings at R-1 (low) and the trend at ‘stable’.

It said the stable trend balances favourable economic and fiscal developments against important downside risks.

“The Cypriot economy benefitted from comparatively strong growth dynamics over the past year with real GDP expanding by 2.5%, aided by robust private consumption and investment activity.

“These favourable economic developments bolstered fiscal performance and contributed to a further decrease in the public debt-to-GDP ratio. The general government budget surplus rose to 2.9% of GDP in 2023 from 2.4% in 2022 as a large increase in public revenues more than offset an upswing in spending.

“General government gross debt declined to 77.4% of GDP in 2023 from 85.6% in 2022 on the back of last year’s fiscal surplus and high nominal GDP growth.”

Looking ahead, Morningstar DBRS said economic developments are likely to remain favourable, underpinned by a further rebound in real wages and still strong investment.

“At the same time, the economy is exposed to downside risks such as an escalation of the military conflict in Ukraine and a prolonged disruption in trade in the Red Sea,” that could weigh on government revenues and raise spending pressures.

Cyprus’ BBB (high) ratings are supported by a stable political environment, the government’s sound fiscal and economic policies in recent years, and a favourable government debt profile, the rating agency said.

“Although governance indicators have weakened over the past years, Morningstar DBRS continues to view the country’s EU membership as an important anchor for institutional quality.

“On the other hand, the credit ratings of Cyprus continue to be constrained by the small size of its service-driven economy, which renders it vulnerable to external shocks.”

The rating agency said Cyprus also faces significant challenges due to a legacy stock of non-performing loans in the banking sector and the economy’s still comparatively low level of labour productivity.

Rebound in tourism, ICT relocations

Growth was driven by a further rebound in tourist arrivals and a continued expansion of information and communications technology (ICT), industries whereas economic activity in business services was weighed down by a step-up of financial sanctions on Russia in spring 2023.

Morningstar DBRS said the economic outlook remains favourable. Private consumption is likely to benefit from a further rebound in real wages and solid employment growth.

Furthermore, investment activity is projected to be bolstered by the inflow of Next Generation EU funds and several major investment projects particularly in the tourism and residential real estate sectors. The Central Bank of Cyprus (CBC) forecasts real GDP growth to strengthen moderately to 2.6% in 2024 and 3.1% in 2025.

The most important industries are trade, tourism, financial and business services and real estate. In addition, economic activity in the ICT sector has increased sharply since 2016 as several foreign ICT companies relocated operations to Cyprus not least as a result of different policy measures (e.g. tax incentives).

However, labour productivity levels of the economy remain below the EU average notwithstanding strong economic growth dynamics in recent years. According to Eurostat, the level of nominal GDP per person employed in Cyprus amounted to only 87.6% of the EU27 average in 2022.

Moderate budgetary pressures are likely to emanate from the revision of the cost of living allowance which leads to a larger automatic adjustment of public sector wages and public pensions to inflation, deficits of the State Health Organisation and from the expansion of state asset management company KEDIPES.

In order to prevent foreclosures for vulnerable households, KEDIPES is planned to acquire eligible primary residences (market value below EUR 250,000) which have been used as collateral in NPLs, and to let those residences to vulnerable households.

Morningstar DBRS understands that the fiscal cost of the expansion of KEDIPES has so far not been incorporated into the government’s budgetary projections.

Public debt on a downward path

The rating agency said Cyprus government debt-to-GDP ratio continued to decline over the past year.

“General government gross debt decreased to 77.4% of GDP in 2023 from 85.6% in 2022 on the back of last year’s fiscal surplus and high nominal GDP growth.

“Looking ahead, continued budgetary surpluses and favourable debt dynamics are projected to lead to a further marked decrease in the debt ratio. The draft budget 2024 forecasts general government debt to decline to a moderate 69.5% of GDP in 2025.”

Morningstar DBRS added that in terms of the government’s interest burden, the projected decrease in outstanding debt helps to offset the impact of the recent increase in interest rates.

The European Commission forecasts general government interest expenditure to decline modestly to 1.4% of GDP in 2024 from 1.5% in 2022.

“The pass-through of higher interest rates has been attenuated by a favourable debt profile following the extension of average debt maturities over the past years. The weighted average maturity of government debt stood at 7.0 years in December 2023, up from 4.5 years in December 2012. Potential short-term funding risks are mitigated by the government’s still large cash buffer that amounted to 9.5% of GDP in December 2023.

“The main risks for public finances emanate from a potential economic shock or a materialisation of contingent liabilities in the large domestic banking sector whose total assets amounted to 263% of GDP in December 2023.”

Morningstar DBRS concluded that the credit ratings are supported by stable political environment.

The election of Nikos Christodoulides as president in February 2023 has not led to major policy changes particularly with regard to fiscal policy and the reforms embedded in Cyprus’s recovery plan, implementation of which will depend on the government’s ability to garner sufficient support in parliament to pass legislation.

“In terms of institutional quality, Morningstar DBRS notes that the country’s ranking in World Governance Indicators (e.g. Control of Corruption, Rule of Law) has deteriorated over the past years and is now below the EU average.

“At the same time, Morningstar DBRS considers the country’s EU membership as an important anchor for institutional quality. With respect to the reunification talks supported by the United Nations, Morningstar DBRS currently assumes that the chances of a significant breakthrough remain limited.”