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
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
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.
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
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
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