November 21, 2012 / 5:51 PM / in 5 years

TEXT-Fitch cuts Cyprus to 'BB-', outlook is negative

Nov 21 - Fitch Ratings has downgraded the Republic of Cyprus's Long-term
foreign and local currency Issuer Default Rating (IDRs) to 'BB-' 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 reflects the materially weaker
macroeconomic outlook, a fiscal budget that has significantly underperformed
expectations and the continued high level of uncertainty over the costs
associated with bank recapitalisation. The delay in negotiating official support
has contributed to the deteriorating economic conditions and raised
uncertainties about public sector reform and the correction of macroeconomic
imbalances. The government's short-term financing flexibility has also been
materially reduced with the its current dependence on bank financing to meet its
funding needs.

ECONOMIC & FISCAL OUTLOOK
The Cypriot economy slipped into its second recession in less than two years in
summer 2011 with the weakness intensifying more than expected into the current
year. With the exception of tourism, all sectors contracted in the third quarter
to September 2012. The economy is on course to shrink by more than 2% this year
after growing by 0.5% in 2011. The contraction is deeper than forecast in
Fitch's review of the rating in June 2012 and Cyprus will remain in recession
into 2014.

A period of adjustment in the public and private sector, which is also highly
indebted, will put significant pressure on domestic demand. Support from the
external sector will be limited by reduced competitiveness and weak prospects
for key trading partners. Greece is the country's biggest export market,
accounting for almost a quarter of total exports in 2011. Persistent macro
imbalances also mean medium-term growth prospects are anaemic. Material downside
risks to the outlook remain.

Cyprus's fiscal position has deteriorated significantly during 2012. In the
April Stability Programme, the government's stated goal was to reduce the fiscal
deficit to 2.6% of GDP for this year from 6.3% in 2011. Data from the Cyprus
Ministry of Finance show that for the nine months to September the fiscal
shortfall already exceeded the level for the same period last year. Fitch
expects the deficit to be over 5% for 2012. This is despite austerity measures,
including wage freezes and an increase in VAT by 2 percentage points to 17%. The
depressed macroeconomic environment dampened receipts, while any expenditure
savings have been offset by an increase in interest and pension expenditure. The
weaker growth outlook will increase the challenge of reducing the fiscal deficit
and the public debt ratio, which is set to remain substantially higher than
before the recession.

In Fitch's baseline scenario, general government debt to GDP will peak around
120% in 2014, up from 71.1% in 2011. The bulk of the projected increase reflects
Fitch's assessment that the Cypriot banks will require further significant
capital injections. The three main Cypriot banks will need at least around a
further EUR4bn (22% of GDP) in addition to the EUR1.8bn already injected into
Cyprus Popular Bank in 2012. There are uncertainties over the capital shortfall
of Cypriot cooperative banks and the overall banking system's recapitalisation
costs could be substantially higher under more stressed scenarios. The capital
backstop facility that will be set under a potential Troika adjustment programme
will likely include a buffer to cover any risk of excess capital requirements
over expectations with the intent to secure confidence and stability in the
banking system.

KEY ASSUMPTIONS AND SENSITIVITIES
Negotiations with the Troika have lasted longer than expected despite recent
progress on setting key capital ratios for banks and the system's supervision. A
request for official aid by Cyprus was made in late June. February's
presidential election risks further delays. However, the agency's ratings are
predicated on Fitch's expectation that the Cypriot authorities will reach
agreement with the Troika on an official financing programme.

The lack of a clear and credible programme to tackle the fiscal and
macroeconomic challenges has negatively impacted business and investor
confidence. The continuation of an unstable environment could translate into
greater fiscal and banking costs for the government. The delays have also raised
concerns about the prospects for fiscal and economic reform. The government's
disagreements with the Troika, also mostly supported by the main opposition
parties, extend to the size of the capital requirement for the banking sector,
the size of cuts in public spending, privatisation of state-owned enterprises
and reforms of the wage indexation system. Resistance to reforms is a key
downside risk to the medium-term fiscal and economic outlook.

The government is possibly able to fund itself for several months until a
EUR1.4bn bond redemption is due in June 2013. Refinancing requirements are low
into the first quarter of next year and are currently being met through T-bills
issued to banks. However, recourse to such funding reduces the government's
ability to respond to adverse shocks and materially increases rollover risks.
This is despite cash deposits and government reserves in state-owned
enterprises. At the end of 2011 Cyprus received liquidity support from the
government of Russia, which financed most of the funding requirements for the
current year. Public statements suggest that a decision by Russia on Cyprus's
request for further support is unlikely in the near term.

NEGATIVE OUTLOOK
The Negative Outlook primarily reflects the risks associated with bank
recapitalisation costs, the short-term financing situation, progress towards a
deficit and debt reduction programme and intensification of the eurozone crisis,
notably further contagion from Greece. A further downgrade could be triggered if
the capital shortfall in the banking sector is materially larger than current
Fitch estimates, government's access to short-term funding becomes restricted or
a lack of progress in negotiations with Troika puts at risk a timely adjustment
programme to address the fiscal and macroeconomic challenges of Cyprus.

Progress on deficit reduction, recapitalisation of the banking sector and reform
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 on a bailout programme that delineates the burden-sharing
arrangements for the Cypriot banks, which is not Fitch's baseline assumption,
would be a further stabilising factor for the rating.

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 Methodology' dated 15 August 2012 are
available at www.fitchratings.com.

Applicable Criteria and Related Research:
Sovereign Rating Methodology

Our Standards:The Thomson Reuters Trust Principles.
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