Due to reduced debt stock and the highest surplus in the Eurozone in 2023 – Positive Outlook
By Panagiotis Rougalas
One week after the upgrade of Cyprus's Cypriot debt by Fitch Rating House to BBB+, Standard and Poor's (S& ;P) the country at BBB+ while also putting the outlook positive.
According to the main points of the “report” that accompanies the assessment of June 14, S&P states that Cyprus presented the highest consolidated budget surplus in the eurozone last year. At the same time, it emphasizes that, by 2027 the stock of public debt will fall below 60% of GDP, in line with the stable growth and fiscal outlook and our expectation that the government will largely achieve its fiscal surplus targets.< /p>
With reference to the banks, the House underlines that, despite the prolonged non-performing loans in the financial system, the Cypriot banks – mainly owned by foreign banks – have turned the page in terms of profitability and capitalization, reducing the risk of potential liabilities towards the government.
Thus, it decided to upgrade the long-term rating of Cyprus to “BBB+” from “BBB” and we gave a positive outlook, while affirming the short-term rating at “A-2”.
The Outlook
According to S&P, the positive outlook reflects upward pressures on sovereign ratings as fiscal and economic outcomes outperform their respective countries. In his view, the strengthening of the financial position of the Cyprus banking system should lead to a greater convergence of domestic financing conditions with those of the wider euro area, with possible positive effects on ratings.
The Bullish scenario
As the House explains, it could upgrade the Cypriot credit rating within the next 12-24 months if it sees further improvements in the resilience of the Cypriot financial system, which continues to be burdened with the highest non-performing loan (NPL) ratio in the EU .A similar action could also occur if residents' very wide current account deficit and overall gross external financing needs eased, easing their concerns about external leverage.
And the Falling scenario
On the other hand, he stresses, they could revise the outlook to stable if, within the next 12-24 months, fiscal progress and commitment to debt reduction weaken. Downward pressures on the rating could also materialize if progress on structural reforms stalls, creating significant delays in Cyprus' funding from the Recovery and Resilience Fund (NextGenEU).
Why they upgraded
Why they upgraded
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In more detail, S&P states in the assessment “report” that the upgrade reflects the progress that Cyprus has made in recent years in addressing fiscal imbalances, amid resilient growth. It predicts that general government gross debt will fall below the Maastricht Treaty limit of 60% by 2027. Last year, the government's consolidated surplus stood at 3.1% of GDP – above their previous expectations – thanks to rising employment levels, strong private sector consumption and the continued phasing in of higher social security contribution rates. Despite spending pressures, they still believe the government will be able to achieve an average consolidated budget surplus of 2.1% of GDP over 2024-2027, our strongest forecast for all 20 eurozone members.
He also emphasizes that the House's improved assessment of Cyprus' creditworthiness also reflects the strengthening of the financial position of Cypriot banks, which for a long time weighed on its assessment of the government's creditworthiness in the wake of the 2012-2013 financial crisis. . He adds that Cypriot banks are pursuing cost-cutting initiatives and redefining their funding profile away from non-resident depositors, while benefiting from windfalls from the higher interest rate environment. “Consolidation in the sector is also likely to support system resilience, albeit at the expense of reduced competition. A growing majority of the system is also foreign-owned – this mitigates the risk of fiscal contagion to the government's balance sheet from a banking system shock, in our view,” he notes.
Shock Resilient
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S&P in its analysis notes that, after last year's slowdown to 2.5%, it believes growth will pick up again to average 3.0% in 2024-2027. It indicates that economic activity has become increasingly diversified in recent years, allowing Cyprus to shake off the effects of the global pandemic of 2020-2021, followed by the imposition of EU sanctions in 2022 against key trading partners, as well as the latest war Israel-Hamas.
Furthermore, the successful implementation of structural reforms under the recovery and resilience plan is likely to be the key to unlocking further growth.
S&P highlights for its part that economic activity slowed to 2.5% last year, only the second time below 5% since 2016. The lagged effects of sanctions against Russia were a key drag on the professional services sector of Cyprus during 2023. Elsewhere, tourism, the other sector with substantial historical ties to Russia, continued to recover, with total tourist arrivals approaching record levels in 2023. Information and communications technology (ICT) exports, a relatively new sector, they also continued to be a key source of real expansion–with related business relocations also having a positive impact on the real estate sector.
It expects growth to accelerate in the coming years and average 3% in 2024-2027. “In the first quarter of 2024, growth accelerated to 3.4%, driven by construction, ICT, tourism and professional services. Despite the growing importance of Israeli tourists in recent years (accounting for 10.7% of total arrivals in 2023), the latest Israel-Hamas war appears to have had a negligible effect on overall tourist flows, with more recent high-frequency figures even showing that Israeli arrivals have begun to surpass previous record levels again after a decline since late last year. The recovery in professional services activity suggests that the burden of sanctions on the sector has passed. Projects under the Cyprus Recovery and Resilience Plan are likely to increase over the period 2024-2025, supporting investment activity, while incurring an additional public debt of just €200 million, as most of the funding is through grants from EU. In the long term, major gas discoveries have the potential to transform the Cypriot economy, possibly even into an energy exporter. However, we understand that production is unlikely to start before 2028, outside our forecast period until 2027,” he emphasizes.
The Recovery Fund
The House believes that the implementation of the reforms in the context of NextGenEU will unlock grants and further support medium-term development. Cyprus is set to receive up to €1.21 billion (4.5% of GDP) in the period 2021-2026, including €1.06 billion in grants, if it implements the agreed reforms. The recovery plan includes measures to strengthen the health care system, increase the efficiency of public services and the judicial system, develop a modernized tax system and support education. However, implementation has been somewhat slow, with disbursement delays. Although the funds have limited fiscal significance, in our view, related reforms are likely to be key to achieving growth and fiscal efficiency.
Christodoulidis and Kypriakos
S&P expects the authorities to maintain their focus on fiscal sustainability, implementing reforms linked to recovery and resilience facilitation, the cost of living crisis and banking sector reforms. “President Nikos Christodoulidis, without party affiliation, won the elections in February 2023 and governs with a minority coalition government made up of smaller parties. In practice, the island's largest political party, Democratic Alarm, often provides support to Christodoulidis in passing legislation. Despite the more fragmented political landscape, especially after the parliamentary elections in May 2021 (which resulted in a slower legislative process), there is a track record of consensus-based policy-making in Cyprus, which we expect to continue,” he comments. .
On the Cypriot side, despite the new external push, the House does not believe that a consensus is likely to be found on how unification will proceed in the short term. He notes that, in January, the United Nations appointed a special envoy to Cyprus for six months in a new effort to resolve the decades-long Cypriot dispute over the reunification of the island. “The northern part of Cyprus has been under the occupation of Turkey since the 1974 coup, in which the Cypriot National Guard attempted to unite the country with Greece. Demographic factors (reunification with the north is more supported by older groups with a living memory of a united island) and continued opposition from major external actors are likely to continue to prevent consensus being reached,'' the House opined.
Inflation and ATA
According to S&P, inflation has moderated for now, but upside risks from private sector wage growth and oil prices remain. It indicates that price growth, as measured by the harmonized index of consumer price inflation, fell to 2.1% in the last reading in April 2024, which is a hold from 3.9% recorded in the same month a year earlier . Non-energy goods appear to have led to a relative flattening of price growth over the past year, offsetting the small pick-up in energy inflation. “Wage growth is rising in line with the AT adjustment, which applies to the public sector and some private sector jobs, and should start to moderate now that past inflation has receded. However, there is still a risk that unadjusted wages will rise further. We note that the total unit labor cost still appears low compared to the corresponding countries in the eurozone”, he explains.
Finally, the House notes that another key potential vulnerability of Cyprus is related to its dependence on imported oil and oil products, which accounted for 87% of gross energy supply in 2022, the highest among all EU members. This exposes the country disproportionately to fluctuations in international energy prices and also explains why Cyprus has a of the highest energy costs in the EU.
