London, 14 November 2014 -- Moody's Investors Service has today upgraded Cyprus's government bond rating to B3 from Caa3. The rating agency has also changed the outlook on the government bond rating to stable from positive and affirmed Cyprus's Not-Prime (NP) short-term rating.
The upgrade reflects the government's progress to date in addressing the country's key challenges with respect to macroeconomic stability, fiscal consolidation and banking sector stability.
The upgrade reflects two key drivers:
1) The consolidation of the government's fiscal position, as illustrated by an expected return to a primary budget surplus from 2014, and the expectation that public debt relative to GDP will level off in 2015.
2) The stabilisation of Cyprus's financial sector through the recapitalisation of troubled banks, which, to some extent, lowers the risk that bank-related contingent liabilities will crystallise on the government's balance sheet.
However, Cyprus's government bond rating remains constrained by substantial credit challenges, including a weak economic outlook and the very high and still rising non-performing loans (NPLs) in the banking sector, which generate further negative risks to the government's balance sheet.
Concurrently, Moody's has today raised the bond ceilings to B1/NP from Caa1/NP, and the deposit ceiling to Caa1/NP from Caa2/NP. In both cases the rise is in line with the change in the government bond rating.
RATING RATIONALE FOR UPGRADE TO B3
The first driver supporting the rating upgrade is the consolidation of the government's fiscal position and the implications for the stabilisation of Cyprus's debt trajectory. Cyprus's fiscal metrics have exceeded the targets set with the Troika (EU, IMF and ECB): In 2013, the primary deficit fell to 2.0% of GDP versus its target of 4.2% in the original programme (under European System of Accounts 95, 'ESA 95'). Most of the measures aimed at permanently reducing the deficit were included in the 2013 budget, and resulted in significant fiscal consolidation of 7.5% percentage points of GDP over 2013-14, according to IMF data.
The fact that the economic contraction in 2013 and 2014 was not as severe as initially expected under the programme also contributed to the government's ability to outperform fiscal targets. In Moody's view, the economic and fiscal outperformance increases the likelihood of the government achieving the rest of its medium-term fiscal consolidation targets, e.g. reaching a primary surplus of 4% of GDP in 2018, and thereby succeeding in its objective of putting debt on a more sustainable path.
Moody's also estimates that the Cypriot government's fiscal deficit will likely come down to around 3% of GDP in 2014, from 4.9% in 2013 and 5.8% in 2012, and that the primary balance will improve by 2 percentage points in 2014, generating about 0.1% of GDP in surplus (under the newly implemented 'ESA 2010' accounting framework). This estimate assumes a contraction of the economy in 2014 by 2.5% in real terms and tight budget execution through 2014 on both expenditures and revenues. It also takes into account the impact of the fiscal measures enacted in 2013, including an increase in the corporate tax rate to 12.5% from 10% and the near-doubling of the withholding tax on interest to 30%, as well as the rationalisation of expenditures.
Comparing the budgeted revenue with the collected one, the government's budget forecasting has proven prudent, says Moody's. For instance, in the government's budget for 2015, revenue (net of borrowing) for 2014 has been revised up by 5.6% compared with budgeted levels, with direct and indirect taxes having been revised up by 2.6%.
Under the rating agency's baseline scenario, assuming a modest and gradual economic recovery from 2015-16 with growth progressively rising to around 2% over the medium term, government debt is expected to peak at around 110% of GDP (under ESA 2010) in 2015, before slowly reversing. Under such scenario, we assume that the €1 billion loan-to-assets swap that the Ministry of Finance intends to complete with the Central Bank will proceed.
The second driver for the upgrade of Cyprus's government rating is the improvement in the stability of the country's financial sector, and in particular the strengthening of the largest banks. Banks' balance sheets have been bolstered through increased capital buffers, external deleveraging (through sales of non-core activities overseas) and improvements in their funding profiles, says Moody's. As a consequence, the sovereign's susceptibility to shocks emanating from the banking sector has decreased to some extent.
The rating agency also notes that the authorities have strengthened the regulatory and supervisory framework, in particular by implementing measures intended to aid banks in dealing with their high NPLs, for instance through the reform of loan foreclosure procedures as set out in a law enacted on 6 September and that was recently enforced by the Supreme Court of Cyprus as it ruled out amendments aimed at diminishing this law.
Moody's notes that while the ECB's Comprehensive Assessment (CA) identified capital shortfalls for Bank of Cyprus Public Company Ltd (BoC), (Ca, review for upgrade/NP/E/ca) and Hellenic Bank Public Company Ltd (Caa3,stable/NP/ E/caa3), based on their financial position as of end of year 2013, BoC has already addressed the capital shortfall through pre-emptive actions this year and Hellenic Bank is in the process of doing so.
The Cooperative Central Bank (CCB, unrated), which is the central body that credit cooperative institutions are affiliated to, is now 99%-owned by the government following its recapitalisation in March 2014, and also passed the CA as the bank took pre-emptive actions. In Moody's view, CCB also shows gradual progress under its restructuring plan. The bank's 96 institutions have been merged into 18, its supervision by the Central Bank of Cyprus has been strengthened, and it had taken measures aimed at improving profitability.
However, there remain a number of risks which balance the credit-positive developments with respect to fiscal consolidation and the stabilisation of the banking system.
First, the continued deleveraging by the heavily indebted household and corporate sectors pose significant risks to the economic outlook. Moody's does not forecast a substantial economic recovery before 2016, and if underlying pressures were to increase by more than expected, the recovery would be postponed, raising further uncertainty over debt sustainability. Even in its base case, Moody's expects government debt to peak at an elevated level of around 110% of GDP in 2015 before leveling off, however slower growth would therefore cause the debt level to peak higher and decline more slowly. In addition, the rating agency notes that if the €1 billion (equivalent to around 6% of GDP) loan-to-assets swap that the Ministry of Finance intends to complete with the Central Bank were to not materialise, this year or in 2015, government debt would peak at around 115% of GDP.
Second, authorities also still face uncertainty over the strength of the banking sector, given the extremely high (48%) and rising level of NPLs across both household and corporate loan books. Provisions against bad loans are low, and banks remain vulnerable to NPLs rising further despite strengthened capital levels. As a result, the balance sheet of the government remains highly susceptible to risks emanating from the banking sector.
Overall, Moody's believes that Cyprus remains in a similar position to other defaulted sovereigns. The underlying problems that led to the country's initial default are not yet fully resolved and the likelihood of redefault will remain elevated for a sustained period of time.
RATIONALE FOR STABLE OUTLOOK
The stable outlook reflects a balance of risks. On the one hand, Moody's expects that the government's commitment to continuing its fiscal consolidation efforts will remain high, and that progress achieved in consolidating public finances and restoring the banking sector will most likely not reverse. On the other hand, the weak economic outlook and the high NPLs in the banking sector continue to pose risks to debt sustainability.
WHAT COULD CHANGE THE RATING UP/DOWN
Upward pressure to Cyprus's government bond rating could result from further fiscal progress under the Troika programme, e.g. if the government's primary surplus were to exceed targets and reach 4% earlier than planned (i.e. before 2018). In addition, evidence that the risks to growth and to the banking sector are unlikely to crystallise would imply upward pressure: higher economic growth and/or a more rapid reversal in the upward trend for banks' NPLs would be credit positive.
Conversely, downward pressure on Cyprus's government bond rating could emerge if the government's commitment to meeting the Troika programme's conditionality and restoring macro-financial stability were to weaken, in particular if the expected low resumption of growth fails to materialise. Evidence of a need to further recapitalise the banking sector would also exert downward pressure on the rating.
RATIONALE FOR RAISING OF LOCAL- AND FOREIGN-CURRENCY BOND CEILINGS
Moody's has raised the local- and foreign-currency bond ceilings of Cyprus to B1/NP from Caa1/NP. It also raised the local- and foreign-currency deposit ceilings to Caa1/NP from Caa2/NP.
The rise in the ceilings reflects the ongoing relaxation of capital control measures and the possibility for depositors to use their deposits for debt repayment under certain conditions. Domestic capital controls have been fully lifted while restrictions on international capital movements remain conditional to size, the nature of transactions, and business purposes. While the plan is for these restrictions to be relaxed, this process will be gradual and will take time to be fully implemented.
GDP per capita (PPP basis, US$): 28,748 (2013 Actual) (also known as Per Capita Income)
Real GDP growth (% change): -5.4% (2013 Actual) (also known as GDP Growth)
Inflation Rate (CPI, % change Dec/Dec): -2.3% (2013 Actual)
Gen. Gov. Financial Balance/GDP: -4.9% (2013 Actual) (also known as Fiscal Balance)
Current Account Balance/GDP: -1.7% (2013 Actual) (also known as External Balance)
External debt/GDP: [not available]
Level of economic development: Medium level of economic resilience
Default history: At least one default event (on bonds and/or loans) has been recorded since 1983.
On 11 November 2014, a rating committee was called to discuss the rating of the Cyprus, Government of. The main points raised during the discussion were: The issuer's fiscal or financial strength, including its debt profile, which has improved. The issuer has also become, to a certain extent, less susceptible to event risks, in particular stemming from the banking sector. Other views raised included: The issuer's institutional strength/ framework and the issuer's governance.
The principal methodology used in this rating was Sovereign Bond Ratings published in September 2013. Please see the Credit Policy page on www.moodys.com for a copy of this methodology.
The weighting of all rating factors is described in the methodology used in this rating action, if applicable.
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