(Repeat for additional subscribers)
April 25 (The following statement was released by the rating agency)
Fitch Ratings has revised the Outlook on Cyprus's Long-term foreign currency Issuer Default Rating (IDR) to Stable from Negative and affirmed the IDR at 'B-'. The agency has also upgraded the Long-term local currency IDR to 'B-' from 'CCC'.
Other ratings have been affirmed with Short-term foreign-currency IDR at 'B' and Country Ceiling at 'B'. The issue ratings on Cyprus's senior unsecured foreign-law bonds have been affirmed at 'B-' and the issue ratings on unsecured local-law bonds have been upgraded to 'B-' from 'CCC'.
KEY RATING DRIVERS
The revision of the Outlook and the upgrade reflect the following key rating drivers and their relative weights:
Reform implementation under the EU-IMF programme continues to progress, supporting policy coherence and credibility. In particular, wages and prices are adjusting downwards in contrast to previous episodes of recession. Driven by spending cuts in the public sector, compensation per employee fell 6% yoy in 2013. In the private sector compensation per employee fell by 5.3%. Fitch expects the government to continue to adhere to programme parameters, following parliamentary approval on privatisation plans despite initial resistance from some political parties.
Fiscal targets have been exceeded by a significant margin. The general government deficit to GDP (GGD) ratio was contained at 5.4% in 2013, below the projected 7.8% under the second Troika review of the programme and Fitch's previous forecast of 6.7%. The outcome reflects a large fiscal correction and a less severe-than-expected recession. Tight expenditure control contributed significantly to the favourable outcome. Fitch has revised its fiscal deficit projections to 5% of GDP in 2014 and 4.6% in 2015, from 7.5% and 6.9%, previously.
The economy has proven to be more resilient than previously expected. GDP contracted 5.4% in 2013, compared with the forecast 7.7% contraction under the second Troika review and Fitch's previous forecast of 7% decline. Tourism and professional services (excluding banking) have shown some resilience. Households have also been using their savings to smooth their consumption. Fitch has revised its GDP projections for 2014 to a contraction of 3.9%, from a 5.1% decline previously.
The risk of a repeat of Cyprus restructuring its domestic law bonds, which occurred in 2013, has reduced, resulting in the Long-term domestic and foreign currency IDRs being equalised. This equalisation is supported by the improved fiscal and economic performance relative to Fitch's previous expectations, leading to stronger financing buffers within the programme.
Cyprus's external debt position has improved compared with Fitch's previous forecast, in part due to favourable revisions to previous official data. The improvement also reflects positive trends in capital flows, including a significantly narrower current account deficit.
Cyprus's 'B-' Long term foreign currency and local currency IDR ratings also reflect the following key rating drivers:
There are still significant risks to creditworthiness posed by Cyprus's continued deep economic and financial adjustment, which is still in its early stages.
The restructuring of the banking sector has also undermined the potential growth of the economy and unemployment will remain elevated in the near term. The stock of NPLs (as per Central Bank of Cyprus's new definition) on average reached 42% of gross loans at end-December 2013, and in some banks, was above 50%. The quality of assets may deteriorate further in the next quarters, albeit potentially at a slower pace. Banks have taken steps to enhance their internal arrears and restructuring processes and now face the challenge of limiting any additional credit deterioration and recovering NPLs without affecting their recently restored capital positions.
Public debt, at around 112% of GDP in 2013, was almost three times higher than the 'B' median of 42% and has yet to peak. There is little further fiscal scope to absorb any additional domestic or external shocks.
Risks to programme implementation have eased on recent performance but remain elevated. Medium-term fiscal targets, in particular, are ambitious. Official projections show a 3.3pp improvement in general government primary balance in 2016 to a surplus of 1.2% of GDP which could prove difficult to achieve. A significant portion of the consolidation also remains outside the programme period which ends in 1Q16.
Cyprus's financing requirements rise significantly after the end of the programme period, which could be challenging for the government. According to projections by the IMF gross financing needs, including for buffers, will rise to EUR3.6bn in 2017 from EUR1.7bn in 2016, with maturing medium- to long- term debt increasing to EUR2.7bn from EUR0.6bn. This includes the EUR1.8bn domestic law bond held by Bank of Cyprus, which can be rolled over annually until 2017. The process of lifting capital controls carries risks, and a premature exit could trigger material capital flight with negative economic consequences.
Future developments that may, individually or collectively, lead to a negative rating action include:
- Significant slippage from programme targets, in particular fiscal deficits, or adverse changes to public debt dynamics, for example, caused by a deeper-than-expected recession or political shocks
- A recession that is materially deeper or longer than assumed by Fitch which would have adverse consequences for public debt dynamics
- Re-intensification of the banking crisis in Cyprus, for example, capital flight from banks if capital controls are lifted prematurely
Future developments that may, individually or collectively, lead to a positive rating action include:
- A longer track record of successful implementation of the EU-IMF programme
- Signs of a stabilisation in economic output and the banking sector
- Improvements in export performance that help facilitate the rebalancing of the economy
- Lifting of capital controls with no material negative economic consequences. A removal of capital controls would also lead to an upgrade of the Country Ceiling.
Fitch expects the recession to be deeper and the downturn to last longer than assumed under the EU/IMF programme. The agency expects output to contract by around 3.9% in 2015 and 1% in 2016 and not return to growth until 2017. This compares with the Troika programme forecast for the economy to grow from 2015. Fitch assumes moderate slippage from Troika fiscal targets in the medium term, especially in 2016 when the primary balance is expected under the programme to improve significantly. The official programme targets a primary balance surplus of 4% of GDP by 2018 from a deficit of 2% in 2013. It is likely that the fiscal adjustment will need to be greater to achieve the ambitious long- term targets for the primary balance, especially as downside risks to growth remain high. Fitch's debt dynamics projections assume the government concludes the asset swap of a portion of the outstanding government debt held by Cyprus Central Bank (EUR1bn), generates proceeds from privatisation (of at least EUR1bn within the programme period and EUR0.4bn outside) and dividends from the central bank (EUR0.4bn).
Public debt has improved slightly from the previous rating review. Fitch expects gross general government debt (GGGD) to peak at 126% of GDP in 2016 (compared with over 131% in the previous review) and to gradually decline to 117% by 2020. The improvement is due to better growth projections and smaller fiscal deficit forecasts in the near term.
Fitch currently assumes that the fiscal costs of bank recapitalisation will not exceed the EUR2.5bn specified under the Troika programme, which includes a contingency buffer of EUR1bn.
Fitch assumes that there will be no material escalation in developments between Russia and Ukraine that would lead to a significant external shock to the Cypriot economy. Tourism from Russia has been rising and Russians account for a sizeable share of foreign deposits in banks. Our projections also do not include the impact on growth of potential future gas reserves off the southern shores of Cyprus, the benefits from which are several years into the future, although now less speculative. A second test drill is planned for autumn. Similarly while talks to resolve the Cyprus issue has resumed after a two-year break we do not expect a solution any time soon.
Fitch assumes Cyprus and the euro zone as a whole will avoid long-lasting deflation, such as that experienced by Japan from the 1990s. However, given the nominal adjustment underway in Cyprus, downward price pressures will be significant over the medium term. This will hinder the balance-sheet adjustment of the public and private sectors.
Fitch assumes the gradual progress in deepening fiscal and financial integration at the euro zone level will continue; key macroeconomic imbalances within the currency union will be slowly unwound; and euro zone governments will tighten fiscal policy over the medium term. It also assumes that the risk of fragmentation of the euro zone remains low.
Link to Fitch Ratings' Report: Cyprus - Rating Action Report