(The following statement was released by the rating agency)
June 25 - Fitch Ratings has downgraded the Republic of Cyprus’s Long-term foreign and local currency Issuer Default Rating (IDRs) to ‘BB+’ from ‘BBB-'. The Short-term IDR has also been downgraded to ‘B’ from ‘F3’. The Outlook on the Long-term IDRs is Negative. Fitch has simultaneously affirmed the eurozone Country Ceiling for Cyprus at ‘AAA’.
The downgrade of Cyprus’s sovereign ratings reflects a material increase in the amount of capital Fitch assumes the Cypriot banks will require compared to its previous estimate at the time of the last formal review of Cyprus’s sovereign ratings in January 2012. This is principally due to Greek corporate and households exposures of the largest three banks, Bank of Cyprus, Cyprus Popular Bank (CPB) and Hellenic Bank and to a lesser degree the expected deterioration in their domestic asset quality.
In addition to the EUR1.8bn (10% of GDP) required for Cyprus Popular Bank (‘BB+'/Rating Watch Negative), Fitch assesses that Cypriot banks will require further substantial injections of capital, potentially up to EUR4bn (23% of GDP). While most of the increase in losses is associated with Cypriot banks’ Greek exposure, the reported non-performing loan ratio for domestic Cypriot loans has also risen notably over the past year as the Cypriot economy has contracted and unemployment has risen. Even assuming that Greece remains in the eurozone, Cypriot banks will have to bear significant further loan losses as the Greek economy continues to contract over the medium term as well as the deterioration in domestic asset quality.
Fitch acknowledges that its estimates of the losses and capital needs of Cypriot banks are subject to considerable uncertainty and are conservative. Nonetheless, in Fitch’s opinion, Cypriot banks will require substantial injections of capital in order to secure confidence in their financial viability. Fitch judges that the scope for further capital-raising from the private sector is limited and thus assumes that the capital will have to be provided by the government. With the fiscal cost of bank support potentially as high as EUR6bn, general government debt is likely to exceed 100% of GDP compared to the agency’s previous forecast of 88%.
The budget has underperformed government expectations in the first half of 2012. Though corrective measures are likely to be introduced, the official deficit/GDP target of 3% is likely to be missed and is forecast by Fitch to reach 3.9% of GDP. Nonetheless, the fiscal adjustment necessary to stabilise the government debt to GDP ratio is moderate relative to several European peers. That said, significant fiscal reform will be required to absorb the economic and financial costs of an aging population and as part of a broader structural reform effort necessary to enhance productivity and international competitiveness,
Fitch judges the near-term liquidity risk faced by the sovereign to be low. Bond maturities are moderate in 2012 and 2013 and fiscal financing is secure for the remainder of 2012. In 2013 the government has EUR2.25bn of refinancing needs, including a EUR1.5bn EMTN redemption in July 2013. Fitch expects Cyprus to secure a bilateral loan, likely from the Russian Federation (‘BBB’/Stable), which will be sufficient to cover the gross budgetary funding requirement up to end-2013. However, the agency also expects that Cyprus will have to secure a loan from the EFSF/ESM to fund the broader recapitalisation of the banking sector. The lack of market access to affordable term finance underscores the constrained financing flexibility of the sovereign to respond to adverse shocks.
The near to medium-term economic outlook for Cyprus is weak. Fitch expects the economy to stagnate this year and next and thereafter to recover only slowly as macroeconomic imbalances unwind and the headwinds from the on-going eurozone and Greek crises persist. However, as these imbalances are resolved, Fitch’s expects the underlying fundamentals of the economy to support a resumption of economic growth over the medium-term. Combined with still moderate effective interest cost and on the assumption that the government reduces the budget deficit below 3% of GDP in 2013 and beyond, government debt sustainability is within reach.
The Outlook on Cyprus remains Negative, indicating a heightened risk of further downgrades. The Negative Outlook primarily reflects the risks associated with a further worsening of the eurozone crisis, notably further contagion from Greece.
In the event of a Greek exit from the eurozone, Fitch would review Cyprus’s sovereign ratings. In such a stress scenario, Fitch’s preliminary estimates are that Cypriot banks could require significantly more capital than currently incorporated into Cyprus’s ‘BB+’ sovereign ratings. However, Fitch also recognises that there could be scope for the sovereign to limit the liability arising from the banks in this scenario. Nonetheless, the uncertainty surrounding the outlook for Greece is a material negative factor in the rating and Outlook for 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. Combined with a resolution of the eurozone crisis, Cyprus’s underlying fundamentals would re-assert themselves and support a return to investment grade status.