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Rating action

Scope Ratings GmbH (Scope) has today upgraded the Republic of Cyprus’s (Cyprus) long-term issuer and senior unsecured local- and foreign-currency ratings to BBB from BBB- and revised the Outlook to Stable from Positive. Scope has also affirmed Cyprus’s short-term issuer rating of S-2 with a Stable Outlook in both local and foreign currency.

Summary and Outlook

Scope’s decision to upgrade Cyprus’ credit ratings to BBB from BBB- reflects:

1. Better-than expected economic performance, including stronger-than-anticipated resilience to the Russia-Ukraine war, and solid growth prospects, underpinned by sound structural reform momentum under the national Recovery and Resilience Plan.
    
2. A very favourable debt trajectory, supported by strong growth, good fiscal performance with a return to budget surpluses already by year-end 2022, and a commitment to fiscal discipline.
    
3. Further strengthening in banking sector vulnerabilities, through curtailed non-performing loans, sound capitalisation and liquidity. These trends have proven resilient to the Covid-19 crisis and the war in Ukraine. Cyprus’s exposure to Russia is limited thanks to pro-active efforts to reduce ties in recent years.

The rating is constrained by Cyprus’s: i) a small, open and externally dependent economy; ii) lingering albeit improving vulnerabilities in the banking sector, as reflected in still elevated non-performing exposures; and iii) high sensitivity to shocks due to large macro-economic imbalances, reflected in high levels of private and public debt, combined with a weak external position.

The upgrade reflects update Scope assessments of Cyprus under the ‘domestic economic risk’ and ‘public finance risk’ pillars of its sovereign methodology.

The Stable Outlook reflects Scope’s view that risks to the ratings are balanced over the next 12 to 18 months.

The ratings/Outlooks could be upgraded if, individually or collectively: i) sustained fiscal consolidation is achieved, resulting in a material decline in public debt; ii) vulnerabilities in the banking sector ease further; and/or iii) resilience to external shocks is strengthened, for instance through the development of high value-added export sectors or lower energy import dependence.

Conversely, the ratings/Outlooks could be downgraded, if individually or collectively: i) the growth outlook deteriorates substantially; ii) the debt trajectory were to reverse, for instance due to fiscal loosening or weakened growth; and/or iii) banking sector fragilities re-emerge which lead to additional liabilities for the sovereign.

Rating rationale

The first driver of the ratings upgrade to BBB is Cyprus’s solid economic performance and strong growth prospects, underpinned by a high growth potential and despite Russia-Ukraine war headwinds. The Cypriot economy outperformed expectations and rebounded strongly in 2021, growing by 6.7%, after the gradual relaxation of Covid-19 containment measures. The swift implementation of government support measures amid the pandemic mitigated the negative economic effects and structural damages to the growth potential. The strong growth momentum continued during 2022 and was broad-based with good performance across virtually all economic sectors. The economy showed remarkable annual growth of 6.2% in the four quarters to September 2022 despite being the euro area economy with the highest direct exposure to Russia and Ukraine, mostly through tourism (which represented around 14% of Cyprus’s GDP in 2019). This was sustained by robust consumption, the expansion of exports and other services such as business and IT services and a better-than-expected recovery in the tourism sector,. The closure of EU airspace for Russia and vice versa as part of the sanctions package introduced in March after the invasion of Ukraine, was expected to have a significant impact on the island’s tourism sector, with Russians representing 20% of tourist arrivals since 2013¹. However, the economy proved resilient to this shock, as the authorities managed to diversify rapidly and effectively the tourism market and tourist receipts reached 78% of 2019-levels for the period January-August 2022, further supporting strong economic performance. Importantly, these positive developments also alleviate Scope’s concerns about the risk of structural damage to Cyprus growth potential given its high direct exposure to Russia and Ukraine vis-à-vis European peers.

There remains uncertainty due to the ongoing conflict in Ukraine and the related energy supply disruptions. Intensifying inflationary pressures, driven by rising oil and gas prices, and rising borrowing costs amid monetary tightening are weighing on growth, but Cyprus has been relatively well insulated compared to European peers. HICP inflation has been among the lowest in the EU, at 8.6% (core inflation of 5.9%) in October 2022, well below the EU average of 13% (7.6%), despite Cyprus’s high import dependence. Medium-term growth prospects for the country remain on a positive trend. Scope projects real GDP growth to reach 5.5% this year, up by 3.5pps compared to previous forecasts in June and well above the 2.7% growth outlined in the government’s 2022-25 Stability Programme², followed by 2.2% in 2023, well above the euro area average (0.7%). Economic growth is then projected to converge towards the growth potential of 3% by 2027 supported by a full recovery in the tourist sector, normalisation of private consumption and investment patterns, together with improving conditions in domestic and external markets.

The government’s national Recovery and Resilience Plan (RRP) and associated investments and structural reforms will be critical for underpinning strong medium and long-term growth and will address structural economic bottlenecks³. The RRP includes EUR 1.2bn (4.3% of GDP) in spending over coming years. Investments and structural reforms under the RRP aimed at enhancing public and local administration, judicial capacities as well as education and skills of the domestic workforce will be key to support productivity growth. At the same time, the plan’s focus on greening the economy will help make Cyprus’s growth model more sustainable. The RRP fits into the country’s EU-sponsored longer-term strategy, “Vision 2035”, aimed at transforming Cyprus’s growth model, diversifying its economy, and improving social outcomes. According to the economic impact assessment carried by the University of Cyprus, if implemented successfully, the RRP can increase Cyprus’s GDP by around 3% in the short-term (2022-23) and 7% in the medium-term (2022-26), together with a boost in employment by more than 2.5% during 2021-26⁴. The country’s solid record of structural reform implementation and EU fund absorption as well as its reform-oriented government underpins Scope’s confidence in Cyprus’s economic prospects despite lingering downside risks. Scope notes positively Cyprus’s achievement of 14 milestone targets under the RRP, as assessed by the European Commission, including steps to green the economy, improve public administration and strengthen governance, among others⁵.

The second driver of the upgrade relates to Cyprus’s better-than-expected budgetary performance, which underpins a robust fiscal trajectory and has placed debt on a firm downward trajectory. After the budget balance deterioration to a 5.8% of GDP deficit in 2020 due to comprehensive Covid-19 support measures, Cyprus’s fiscal fundamentals improved swiftly in 2021 with the fiscal balance improving substantially to -1.2% of GDP on the back of stronger economic recovery, buoyant revenues, and partial withdrawal of pandemic measures. Cyprus’s budgetary performance continued to outperform expectations in the first seven months of 2022, recording a surplus of 0.6% of GDP, driven by higher-than-anticipated growth and sustained public revenue (expected to increase by 10.6% in 2022), particularly from production and import sectors. This contributed to offset the increase in expenditure mainly to finance household support measures in the context of rising inflation as well as emergency financial assistance to Ukrainian refugees. As such, Scope projects the budget balance to reach 1.2% of GDP this year, a stark improvement compared to the previous forecast of a deficit of 2% of GDP.

In line with the RRP, the government’s medium-term budgetary strategy aims at maintaining fiscal support for the economy near-term, whilst preserving fiscal sustainability and reducing public debt in a sustainable manner longer-term. Financial support measures adopted by the government to mitigate the inflationary pressures for households amid the ongoing conflict in Ukraine amounted to EUR 300m (1.2% of GDP) and their implementation will be extended at least until the first months of next year⁶. Positively revised growth and strengthened fiscal performance, however, anchor our expectations for materially improved fiscal outcomes in coming years. This is further underpinned by the government’s good record of fiscal discipline and the large primary surpluses regularly posted prior to the Covid-19 crisis averaged 2.7% of GDP over 2015-19 and strong commitment to prudent budgetary policies, as reflected in the Stability Programme 2022-25. Scope’s baseline projections see the budget deficit continue improving and steadily reach 2% of GDP by 2027. This will contribute to keep the public debt on a firm downward trajectory and grants the country substantial fiscal space if more fiscal support for the economy is needed.

Strong economic growth, improving fiscal performance, higher inflation and the expected reduction in large cash buffers accumulated during 2021 support a firm decline in Cyprus’s public debt ratio. After having risen sharply to 115% of GDP in 2020, up from 91% the year before, the debt-to-GDP ratio declined by almost 14pps to 101% in 2022. Scope expects Cyprus’s public debt to decline to 87.5% of GDP next year, already below pre-pandemic levels. Public debt should continue declining to 63% of GDP by 2027, converging with the 60% of GDP Maastricht limit. In this case, Cyprus will realise one of the strongest public debt reductions among EU countries. Importantly, Scope’s stressed scenario, which includes a combination of macro-fiscal and interest rate shocks, would still result in declining public debt, albeit at a more moderate pace. The benefits of strengthening medium-term fiscal performance for debt sustainability are also reinforced by improvements in Cyprus’s public debt profile thanks the country’s pro-active debt management strategy⁷. The average maturity of marketable debt stood at 7.9 years as of July 2022, from 4.9 years in 2016 , the share of short-term debt stood at 0.7%, while 71% of total debt is fixed rate. This will help cushion the effects of higher interest rates on Cyprus’s interest payment burden. Finally, the debt management strategy commits to maintaining a cash buffer sufficient to cover more than 100% of the country’s gross financing needs throughout the next 9 months of 2023. As of July 2022, the liquidity buffer was almost three times above this objective.

The final driver of the upgrade is Cyprus’s substantial progress in reducing banking sector vulnerabilities, mainly in the form of the non-performing exposures (NPEs), which have constituted a key credit challenge for the country since the 2012-13 domestic financial crisis. The NPE ratio reached 9.4% in March 2022 down from 27% in March 2020 and from the 2014 peak of 49%. Importantly, the NPE ratio continued to improve in the wake of the Covid-19 pandemic even after the withdrawal of emergency support measures despite early fears of a rapid deterioration in asset quality. Scope expects NPEs to continue declining thanks to the enhanced and tested legislative framework for NPE management and sales completed in 2022 but not yet reflected in the data. Financial exposure to Russia is limited with 3.8% of deposits belonging to Russian nationals and 0.8% of loans in Cyprus banks exposed to Russia. Risks related to the re-emergence of fragilities given the still-elevated legacy NPEs and new NPEs amid rising interest rate environment remain, although they are mitigated by the country’s favourable economic outlook and the significantly reduced size of the banking sector, which shrank from 4x of GDP in 2014 to 2.9x of GDP at end-2021.

In addition to improved asset quality, the Cypriot banking sector is better positioned to face shocks in view of stronger capitalisation and liquidity levels which remained at comfortable levels throughout the Covid-19 crisis. Banks’ capital positions remained strong with a tier 1 ratio of 18.9% in March 2022, broadly unchanged since year-end 2019 while the sector’s liquidity coverage ratio reached a comfortable 351.9% in Q2 2022, up by almost 8pps from the same quarter in 2021. As such, the sector has demonstrated its improved resilience throughout recent crises. With a stronger financial footing, more limited systemic importance, and an improved institutional capacity to manage with NPEs, the risks stemming from Cyprus’s banking sector to the sovereign have declined in recent years though they remain a key credit challenge. According to IMF estimates, contingent liabilities from the banking sector stand at around 8% of GDP⁸.

Beyond banking sector vulnerabilities, Cyprus’s BBB rating continues to be constrained by additional factors.

Cyprus’s small, open economy remains reliant on a few externally-dependent sectors such as financial and business services, tourism-linked activities as well as the construction sector, which have been the main growth drivers in recent years. These sectors are heavily reliant either on external demand or foreign funding. Vulnerability to external shocks is high given the nearly two thirds of real GVA and employment are tied to these sectors. The materialisation of an adverse scenario whereby the global economic outlook deteriorates substantially and external demand drops could leave Cyprus more exposed than peer countries. Scope notes positively that Cyprus’s economic resilience has outperformed expectations in the context of the Covid-19 pandemic and the energy crises. Successful implementation of reforms under the RRP and Vision 2035 is nevertheless critical to reallocate resources to other promising high value-added sectors such as higher education, renewable energies, agri-tech or ICT solutions for instance.

In addition, large macro-economic imbalances, such as still high levels of public, private and external debt constrain the BBB ratings. Households are particularly vulnerable to unexpected shocks and required expenses⁹ and their debt, at 79% of GDP in Q2 2022, is the fourth highest in the EU after Denmark, the Netherlands and Sweden, although it is well below the 2013 peak of 130% of GDP. Nonfinancial corporate debt levels, although declining in recent years from the 2015 peak of 223% of GDP, remain very high with financial liabilities standing at 160% of GDP as of Q2 2022, well above the euro area average (81% of GDP). In addition to this, Cyprus’s external position continues to be characterised by large imbalances. Sustained current account deficits have resulted in a net international investment position of -107% of GDP as of Q1 2022, while external debt stands at 640% of GDP as of June 2022. Scope expects the current account deficit to stabilise, after narrowing to 6.8% of GDP in 2021 from 10.1% of GDP in 2020, thanks to a recovery in exports offset by deteriorating terms of trade and import growth. Still, external imbalances are somewhat overstated due to the prevalence of special purpose entities that have a limited link to the real economy, but they remain an important source of risk. The IMF has highlighted that Cyprus’s external sector remains exposed to liquidity and other risks given large external gross financing needs (over 150% of GDP)¹⁰. These elements, combined with an already high public debt, increase the economy’s sensitivities to shocks and can lead to mutually reinforcing negative feedback loops in a highly stressed scenario.

Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides an indicative credit rating of ‘bbb+’ as regards Cyprus. The ‘bbb+’ indicative rating is further supported by the methodology’s reserve currency adjustment which provides a one notch uplift to the CVS indicative. The ‘a-’ indicative ratings can thereafter be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses against a peer group of countries.

For Cyprus, the following relative credit weaknesses have been identified: i) macro-economic stability and sustainability; ii) current account resilience; iii) external debt structure; iv) resilience to short-term shocks; v) banking sector performance; vi) financial imbalances; vii) environmental risks; and viii) institutional and political risks.

Combined relative credit weaknesses identified in the QS generate a two-notch downward adjustment to the ratings and indicate a sovereign credit rating of BBB for Cyprus.

A rating committee has discussed and confirmed these results.

Factoring of environment, social and governance (ESG)

Scope explicitly factors in ESG sustainability issues during its rating process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 25% weighting under the quantitative model (CVS) as well as in the methodology’s qualitative overlay (QS).

Environment-related credit risks for Cyprus are elevated. Cyprus is particularly vulnerable to the adverse effects of climate change due to droughts, water scarcity and extreme temperatures given its position as a small Mediterranean island state. In addition, the country faces meaningful transition risks. Even though it accounts for just 0.26% of total GHG emissions in the EU, Cyprus’s economy is among the most carbon intensive in the EU. Total greenhouse gas emissions have increased substantially compared to 1990, and both its greenhouse gas intensity and its emissions per capita are above the EU average. Emissions reduction has lagged that of other EU states with a 4.1% decrease since 2005, below the EU-wide reduction of 19% over the same period. This is compounded by the physical constraints of its position as a small island state with limited natural resources and a rapidly growing population and economy which pose environmental sustainability concerns, as highlighted by the European Commission¹¹. Despite the country’s vast supply of renewable sources of energy, including solar, investment in this area is lagging and the economy still heavily relies on fossil fuels, which represented 89% of its gross inland energy consumption in 2020. The share of renewable energy reached about 17% in 2021 and the country’s renewable energy target of reaching 22.9% share by 2030. The country’s National Energy and Climate plan sets emission reduction targets of 21% compared to 2005, in line with the 24% target under the Effort Sharing Regulation when available flexibilities are taken into account. Plans to reduce emissions include a long-term strategy for building renovation, projects aimed at developing a natural gas system, the rollout of a renewable energy roadmap, investments to encourage a shift towards green mobility and a proposed carbon tax. These efforts will be supported by the RRP that includes reforms and investments to green the economy which will be critical to ensuring the environmental sustainability of Cyprus’s growth model. Planned policies are insufficient to meet Cyprus’ climate goals on a stand-alone basis however, with the country relying on flexibilities under the Effort Sharing Regulation to meet its binding targets.

As regards social-risk factors, the quantitative model score is constrained somewhat by an ageing society in an international context, reflecting an increasing old-age dependency ratio over the long-term, although from a lower level than many peer economies. Cyprus performs relatively well in terms of poverty and income inequality relative to peers and has posted one of the strongest improvements among EU countries regarding the share of the population which is at risk of poverty or social exclusion, reducing this ratio by 7.6pps over 2015-20. Cyprus performs poorly in terms of education outcomes, with its PISA scores ranking consistently among the lowest EU performers despite spending more on education than other EU countries (5.9% of GDP versus a 5.0% EU average). In addition, Cyprus’s human capital performs poorly in terms of digitalisation capacity with shortfalls in terms of available ICT specialists and digital skills among nationals. The underperformance of the education system despite relatively high public spending weighs on human capital formation and could constitute an impediment to future growth and diversification of the economy. Similarly, youth unemployment and the number of young people not in employment education or training remain at high levels.

In terms of governance related factors, the country benefits from relatively strong performance on the World Bank’s Worldwide Governance Indicators though it underperforms the EU average. The president, Níkos Anastasiádis, was re-elected in 2018 for another 5-year term although with continued minority control over parliament following legislative elections in 2021. Only 17 of 56 seats are currently held by the Democratic Rally, the president’s party. Geopolitical risks persist on the island in view of the division of the country between Greek and Turkish speaking communities. Negotiations over the reunification of the country have been deadlocked since talks broke down in April 2021, although unofficial dialogue remains open. Tensions between Cyprus, Greece, the EU and Turkey over competing claims to hydrocarbon reserves persist and have intensified. The political shift in Northern Cyprus towards a more nationalist leadership and increasingly antagonistic actions by Turkey are likely to hamper progress towards a UN-led solution.

Rating Committee
The main points discussed by the rating committee were: i) recent economic and fiscal developments; ii) banking sector resilience ; iii) debt trajectory and contingent liabilities; iv) geopolitical situation; and v) peer comparisons.

Rating driver references
1. Cypriot Ministry of Finance (2021)
2. Cypriot Ministry of Finance (2022)
3. Cypriot Ministry of Finance (2021)
4. Economics Research Centre, University of Cyprus (2021)
5. European Commission (2022) 
6. Cypriot Ministry of Finance (2022) 
7. Debt Management Office (2022) 
8. IMF (2022)
9. Eurostat (2022)
10. IMF (2022)
11. European Commission (2022)

Methodology
The methodology used for these Credit Ratings and/or Outlook(s), (Sovereign Rating Methodology, 27 September 2022), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. Also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.

Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With Rated Entity or Related Third Party participation   NO
With access to internal documents                                 NO
With access to management                                          NO
The following substantially material sources of information were used to prepare the Credit Ratings: public domain
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Thibault Vasse, Associate Director
Person responsible for approval of the Credit Ratings: Dr. Giacomo Barisone, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 19 October 2018. The Credit Ratings/Outlooks were last updated on 24 June 2022.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
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