Fitch Upgrades Cyprus to 'BBB-'; Outlook Stable

After S&P, Fitch also elevates Cyprus to investment grade
22 October 2018
Fitch Upgrades Cyprus to 'BBB-'; Outlook Stable

Fitch Ratings-London-19 October 2018: 

Fitch Ratings has upgraded Cyprus's Long-Term Foreign-Currency Issuer Default Rating (IDR) to 'BBB-' from 'BB+'. The Outlooks are Stable. 

A full list of rating actions is at the end of this rating action commentary.


The upgrade of Cyprus's IDRs reflects the following key rating drivers and their relative weights:

Buoyant fiscal revenue and prudent fiscal policy mean we expect Cyprus will record a fiscal surplus of 2.7% of GDP in 2018, compared with a target of 1.7% in the April 2018 Stability Programme Update and a current 'BBB' median fiscal deficit of 2%. We forecast the fiscal surplus will remain high at 2.4% and 2.2% of GDP in 2019 and 2020, respectively, compared with 3.1% and 2.9% targeted in the 2019 Draft Budgetary Plan. Robust economic growth will boost fiscal receipts, while previously adopted hiring freeze and collective agreements will likely limit growth in the wage bill.

Cyprus' gross general government debt (GGGD)/GDP will remain on a firm downward trajectory, despite a one-off expected increase in 2018. Following the placement into Cyprus Cooperative Bank (CCB) of EUR3.19 billion government bonds (15.5% of GDP) to facilitate the acquisition of part of the state-owned bank by Hellenic Bank (HB), GGGD/GDP is set to increase to 104.4% at end-2018 from 95.7% in 2017. However, we expect large primary surpluses, robust growth and contained nominal effective interest rates will reduce GGGD/GDP to 70% of GDP by 2027.

The ratio of non-performing exposures (NPEs) to total loans decreased to pro-forma 40.3% in 1H18 from 44% in 2017 as per the Central Bank of Cyprus, partly supported by the announced securitisation by Bank of Cyprus (BoC) of EUR2.7 billion gross NPEs, which is still subject to regulatory approval by the European Central Bank. The acquisition by HB of CCB's good assets and the subsequent transfer into a run-off entity of CCB's EUR5.7 billion NPEs portfolio are estimated to have led to a further decrease in NPEs to 30% in September 2018. This will support a substantial decrease in contingent liabilities stemming from the banking sector, although these remain large.

The government has taken further decisive steps to address legacy issues within the banking sector. Key legislative amendments aimed at facilitating NPEs securitisation and sales of loans, and strengthening foreclosure and insolvency toolkits were adopted by the parliament in July. The government also intends to launch a subsidy scheme to defaulting borrowers (Estia scheme) in January 2019, which implies loan restructurings and state subsidies to incentivise loan repayment. So far, use of foreclosure instruments has been negligible and the degree of implementation of the scheme and enforcement of the new legislative package remains uncertain.

Additional fiscal costs could arise from potential calls on the government-guaranteed Asset Protection Scheme, covering unexpected losses on EUR2.6 billion of CCB's assets acquired by HB. State subsidies related to the Estia scheme and increased debt servicing costs following government support to CCB are estimated at a yearly 0.5% of GDP by the government and are already captured in our forecasts.

Cyprus is benefitting from a strong economic recovery with real GDP reaching pre-crisis level and the economy forecasted by Fitch to grow 4% in 2018 and 3.8% in 2019, supported by large foreign-financed investment projects in construction and tourism, and robust private consumption.

Cyprus's 'BBB-' IDRs also reflect the following key rating drivers:

Cyprus's ratings are supported by a high level of GDP per capita, strong governance indicators and a favourable business environment significantly above 'BBB' rated peers' and closer to 'A' category peer levels.

Private sector debt and non-performing exposures remain high, however, at 226% (excluding special purpose entities) and 97% of GDP in 1Q18, respectively, and constrain credit growth. Household and corporate debt stood at 105% and 121% of GDP and a large part of the recent decline in such debt stemmed mostly from high GDP growth, debt-to-asset swaps, loan write-offs, rather than loan repayment.

We expect private sector deleveraging will accelerate, however, as enforcement of new legal amendments, improving earnings and recovering house prices foster debt repayment. Economic growth will likely remain resilient to a faster resolution in NPEs as rising wages, a dynamic labour market and high household savings will help preserve disposable income and smooth consumption.

The banking sector remains extremely weak as reflected by Fitch Banking System Indicator (BSI) of 'b'. Very weak asset quality and high NPE ratios are still weighing on new lending and profitability. The acquisition of CCB's healthy assets by HB, respectively the second- and third-largest banks of the country, will result in further concentration within the sector between the two large national banks, with total banking sector's assets still accounting for a high 336% of GDP at end-1H18 (352% at end-2017). Unreserved NPEs for BoC and HB will also decrease to an estimated EUR3.8 billion (19% of GDP) following the sale of CCB assets and BoC transaction, but could lead to some capital shortfall if losses are crystallised and higher-than-expected haircuts incurred on collateral. This level of unreserved NPEs is significant relative to the banks' common equity Tier 1 capital, highlighting their vulnerability to asset quality shocks.

Banking sector liquidity has improved after a 0.8% decline in deposits in 1Q18 due to uncertainty around the CCB sale. A highly indebted private sector has led to an accumulation of liquid assets and a decrease in the loan-to-deposit ratio to 91% in July 2018 (104% in 2017). Non-resident deposits in locally active credit institutions, however, still represent 29.5% of total deposits in 1H18, albeit on a declining trend. These are largely short-term funding and confidence-sensitive and would likely become more volatile than domestic deposits in case of stress.

Fitch forecasts the current account deficit will widen to 6.7% of GDP in 2018 and 7.2% in 2019, compared with the current 'BBB' median of 1.6%, as strong domestic demand, especially in the construction sector, fuels imports. When excluding special purpose entities (SPEs) including shipping and financial companies that materially distort external statistics, the current account deficit decreases substantially, according to the Central Bank of Cyprus. Cyprus's net external debt (NXD) turned into a small asset position in 2Q18, when adjusted for SPEs, compared with a non-adjusted NXD of 154% at-end 2017 and a current 'BBB' median of 7.7%.

Cyprus's financing flexibility has improved substantially since the country exited the macroeconomic adjustment programme in March 2016. The government improved access to capital markets by issuing Eurobonds in June 2017 and September 2018. The sovereign has a large cash buffer, which accounts for 11% of GDP and covers more than the government's medium-term debt management strategy of prefunding the next nine months of gross financing needs.

Fitch has revised the Country Ceiling to 'A' from 'BBB+'. It is now four notches above the Long-Term Foreign-Currency IDR, up from three previously. This reflects Cyprus's recent structural economic and financial sector adjustments and reduced risk of capital controls. It is still below the maximum possible six-notch uplift for eurozone member states, owing to the weakness of the banking sector and recent history of capital controls.

Fitch's proprietary SRM assigns Cyprus a score equivalent to a rating of 'A-' on the Long-Term Foreign-Currency (LT FC) IDR scale.

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:
-External: -1 to reflect the high share of non-resident deposits in the banking sector, recent history of capital control and banking crisis. Although external financing flexibility has improved, these factors still point to risks over and above those captured in the SRM.
- Structural features: -2 notches, to reflect the banking sector weakness that could pose large contingent liability to the sovereign and lead to macro-stability risks.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

Future developments that may, individually or collectively, lead to a positive action include:
-Materially reduced contingent liabilities to the sovereign stemming from the banking sector, for example from declining NPEs or an upgrade in the sector's Viability Ratings;
-Marked reduction in the GGGD/GDP ratio; and
-Continued deleveraging of the private sector.

Future developments that may, individually or collectively, lead to a negative action include:
-Heightened risks in the banking sector, for example from deterioration in asset quality; and
-Stalling of the decline in the government debt-to-GDP ratio, for example due to deterioration of budget balances, weak growth or materialisation of contingent liabilities.

Gross government debt-reducing operations such as future privatisations are not considered in Fitch's baseline scenario. The projections also do not include the impact of potential future gas reserves off the southern shores of Cyprus, the benefits from which are several years into the future.

Fitch does not expect substantial progress with reunification talks between the Greek and Turkish Cypriots over the next quarters. The reunification would bring economic benefits to both sides in the long term but would entail short-term costs and uncertainties.

The full list of rating actions is as follows:

Long-Term Foreign- and Local-Currency IDRs upgraded to 'BBB-' from 'BB+'; Outlook Stable
Short-Term Foreign- and Local-Currency IDRs upgraded to 'F3' from 'B'
Country Ceiling upgraded to 'A' from 'BBB+'
Issue ratings on long-term senior unsecured local-currency bonds upgraded to 'BBB-' from 'BB+'

Source: Fitch Ratings
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