TEXT-Fitch cuts Cyprus rating to 'B', outlook is negative
Jan 25 - Fitch Ratings has downgraded the Republic of Cyprus's Long-term foreign and local currency Issuer Default Rating (IDRs) to 'B' from 'BB-'. The Short-term IDR has been affirmed at 'B'. The Outlook on the Long-term IDRs is Negative. Fitch has simultaneously affirmed the Country Ceiling for Cyprus at 'AAA'. RATING RATIONALE The downgrade of Cyprus's sovereign ratings partially reflects the agency's view that the size of the government support to the banking sector is likely to be higher than previous Fitch estimates, which mainly focused on the three largest banks. Uncertainty regarding the capital needs of the cooperative banks remains. Including the latter, the total recapitalisation costs of the banking sector could be up to EUR10 billion, although Fitch anticipates that this figure may include a degree of headroom. If fully realised it would increase the size of the necessary official support programme for the Cypriot sovereign to over EUR17 billion. In this scenario Fitch forecasts that government debt to GDP would jump to over 140% in 2013. This is significantly higher than Fitch's previous estimate of peak debt of 120% of GDP and materially lowers the creditworthiness of the sovereign. Fitch's estimates of the potential losses and capital needs of Cypriot banks are sensitive to various assumptions, which are subject to change as the situation unfolds. Negotiations between the Troika and the authorities have been protracted and are still ongoing, with lingering uncertainty about the timing and details of an EU-IMF rescue programme. A request for official aid by the Cypriot government was made in June 2012. While agreement has been reached on the size and type of the fiscal adjustment, disagreements remain on the potential privatisation of state owned enterprises (SoEs) and the bank recapitalisation costs. The latter, combined with the uncertainty over prospects for fiscal consolidation and the depth and duration of the economic recession, also increase uncertainty over the long run trajectory of public finances. KEY ASSUMPTIONS AND SENSITIVITIES Cyprus's 'B' rating is supported by Fitch's expectation that the Cypriot authorities will reach agreement with the Troika on an official financing programme before 3 June when a EUR1.4 billion bond redemption is due, thereby removing any near-term risk of a payment default. Elections will take place in February and a Memorandum of Understanding (MoU) could be signed by a new President soon after. The incumbent is not standing for re-election. In the agency's view, European policy-makers will be unlikely to pursue a restructuring of Cypriot sovereign debt, given that it would not provide significant debt relief. According to data provided by the Cyprus Ministry of Finance, more than 70% of total government debt - excluding existing capital injections into the banking sector - is held by the domestic banks and official creditors, including the EUR2.5bn loan from Russia. Debt restructuring would also weaken the credibility of Eurozone policy makers who have said Greece's private sector involvement (PSI) was an exception and it could create contagion risks for other eurozone countries. The fact that some of the debt held by foreign investors is covered by international law could also add to the costs and uncertainty of PSI. As part of a final agreement with the Troika Fitch expects that the Cypriot government will privatise some SoEs but there is uncertainty over how much debt relief can be achieved from this source. Fitch anticipates that any restructuring of bank debt would be restricted to junior debt holders, though banks are mostly deposit financed, which limits the potential impact. Moreover, Fitch does not discount the possibility of mutualisation of bank recapitalisation costs with eurozone partners at some point, for example through the European Stability Mechanism (ESM). The agency assumes that the government will retain sufficient access to short term financing. Its net funding needs over the coming months could be met through a combination of issues of Treasury bills to SoEs and banks and available cash reserves. The agency thinks it is highly unlikely there would be a disorderly default stemming from the government running out of cash before the June bond payment. NEGATIVE OUTLOOK The Negative Outlook primarily reflects the continued policy uncertainty. The timing and parameters of an official aid programme have yet to be agreed. This agreement will be needed by 3 June in order to avoid a payment default. The final details will depend on the Troika and the government's assessment of debt sustainability which has not yet been finalised, as the assessment of the bank recapitalisation costs is still being completed. A further downgrade could be triggered by materially higher than current Fitch estimates of bank recapitalisation costs. Failure to implement the fiscal consolidation outlined in the government's multi-year budget plan would also be negative for the rating, as would any unanticipated policy decisions that increased the probability of a debt restructuring or payment default. Progress on deficit reduction and reforms to address medium-term challenges arising from an aging population and low productivity growth would support a stabilisation of the rating. An agreement with the Troika that credibly supports the Cypriot banking sector would also help to stabilise the rating. Any mutualisation of bank recapitalisation costs with euro zone partners in the future would be a rating positive. ECONOMIC & FISCAL OUTLOOK Fitch expects the recession to deepen in 2013 with GDP shrinking by 3.5%. Cypriot GDP likely contracted by 2% in 2012 after growing by a mere 0.5% in the previous year. The economy will struggle to grow until 2015. This compares with the average growth of 4% per year prior to the global economic and financial crisis. A period of adjustment in the public and private sector, which is also highly indebted, will put significant pressure on domestic demand. The weakened economies of key trading partners in Europe and reduced competitiveness will limit the upside from exports. Half of all foreign trade goes to the EU and almost a quarter to Greece. Whilst Russia and the Middle East are growing trading partners for Cyprus, they are not yet large enough to substitute for lost EU exports. The risks to the near term outlook are on the downside. The size of the fiscal multiplier is uncertain and private demand is subject to other downside risks. Lingering uncertainties over the bailout programme could further negatively impact business and consumer confidence. The trade channel effect of a weaker EU could also be significant. In the long run there could be benefits from the recent discovery of oil and gas reserves in the waters between Cyprus and Israel. The government claims the reserves could be developed for domestic use by 2017 and can provide export revenue from 2019. Fitch believes this is a best case scenario and that setbacks are likely. There is also uncertainty about how much of the reserves are commercially viable. The authorities, however, estimate the government revenues from Block 12 alone would range from EUR18.5 billion (103% of GDP) to EUR29.5 billion (164% of GDP) depending on the method of extraction. Cyprus's budget position has deteriorated significantly during 2012. The fiscal deficit for last year is likely to be over 5% of GDP, which compares with the 6.3% of GDP deficit in 2011. The government has already started to implement the provisions of its draft MoU. Out of a total fiscal adjustment of 7.25% of GDP 5.5% have been specified and incorporated in the draft MoU. Even with the full implementation of the planned fiscal adjustment, debt to GDP would peak over 140% assuming a EUR10 billion recapitalisation of the banking sector. This debt ratio would then fall to around 120% by 2020 under Fitch's projections, with the working assumption that the full cost of bank support remains a liability of the Cypriot government. There are risks to the government meeting its fiscal targets. The economic downturn will make it hard to implement austerity measures and revenue generation from tax increases could undershoot expectations. There is also the risk that the economy will underperform the baseline with knock-on effects for the fiscal balance. The authorities will need to achieve a primary fiscal surplus of 4% of GDP from 2016 onwards to bring the debt to GDP ratio close to 120% by 2020. Since 1990 the government has only managed to achieve a primary fiscal surplus of at least 4% in 2007 when the Cypriot economy was growing by more than 5%. Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings. Applicable criteria, 'Sovereign Rating Criteria', dated 13 August 2012, is available on www.fitchratings.com. Applicable Criteria and Related Research: Sovereign Rating Methodology
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