Panayiotis Rougalas
The German Scope Ratings have given a positive sign for Cyprus by upgrading the country to BBB+ last Friday from the previous BBB while keeping the outlook of the economy stable. Following the German rating, Cyprus now has five out of five (5/5) good ratings from the Scope Rating Houses in the second cycle of the 2023 ratings. It is worth noting that, according to a decision of the European Central Bank, Scope Ratings has been accepted as the fifth credit rating agency after Moody's, Fitch, Standard and Poor's, and DBRS Morningstar.
According to the ratings report, Scope's decision to upgrade Cyprus' credit rating to BBB+ from BBB reflects a very favorable debt trajectory leading to steadily declining debt levels. This is supported by strong growth, resilient fiscal performance with a return to fiscal surpluses as early as the end of 2022, and a commitment to continued fiscal discipline. As documented by the House, there is better-than-expected economic performance in the country, which continues to demonstrate resilience amidst the adverse external environment and inflationary pressures. This is coupled with solid medium to long-term growth prospects compared to peers, also supported by healthy structural reform momentum and public investment under the National Reform Programme and Recovery and Resilience Plan.
At the same time, the House sees continued improvements in the financial sector and a reduction in its size overall. It says banks' NPL ratios are falling even amidst the pandemic and cost of living crises, boosting capitalization levels.
However, Scope's BBB+ rating is constrained by three factors. First, Cyprus' small, open, and externally dependent economy. Second, by persistent, albeit improving, vulnerabilities in the banking sector, as reflected in still elevated non-performing exposures. Third, by high vulnerability to shocks due to large macroeconomic imbalances, reflected in high levels of private and public debt, coupled with a weak external position.
The Germans did not miss an opportunity to criticize their frequent suspensions of divestments in their report. In presenting the rationale behind the BBB+ rating, analysts at Scope Ratings suggest that banking sector vulnerabilities remain a key credit challenge and could worsen in the context of higher inflation and interest rates. This is while further reductions in NPLs are complicated by delays in the implementation of the foreclosure law and frequent suspensions of foreclosures (divestment framework).
Nevertheless, they note that the NPL ratio reached 7% in June 2023, down from 9.3% in June 2022 and from the 2015 ceiling of 48%, according to IMF data. Importantly, according to Scope, the NPL ratio continued to improve after the COVID-19 pandemic and the cost-of-living crises. In addition to improved asset quality, the Cypriot banking sector is better positioned to weather shocks due to stronger capitalization levels, with the capitalization ratio continuing to improve to an all-time high of 21% in June 2023, up from 19.5% in June 2022. Additionally, the size of the banking sector further declined to 236% of GDP, down from 631% in 2012.
According to the German Rating Agency, Cyprus' small, open economy remains dependent on a few external sectors such as financial and business services, tourism-related activities, as well as the construction sector. "These sectors are heavily dependent on either external demand or foreign financing. The vulnerability to external shocks is high given that almost two-thirds of real gross value added and employment are linked to these sectors," they comment. In addition, the country's dependence on energy imports is high, with almost 90% of its energy needs to be met through imports in 2021. Scope notes that the successful implementation of reforms under the national recovery plan and long-term economic strategy is critical to reallocating resources to other promising high-value-added sectors such as higher education, renewable energy, agriculture, health, and ICT companies.
A second vulnerability, according to the House, is the large macroeconomic imbalances, including still high levels of private and external debt, which limit BBB+ ratings. Household debt, at 69% of GDP in Q2 2023, is the fifth highest in the EU, although it is much lower than the 2015 ceiling of 131% of GDP. "Non-financial corporate debt levels, although reduced in recent years from the 2015 ceiling of 223% of GDP, remain very high with financial liabilities reaching 142% of GDP by the second quarter of 2023, well above the euro area average (around 80% of GDP)," they explain.
Finally, Cyprus' external position continues to be characterized by large imbalances. Sustained current account deficits led to a net international investment position of -102% of GDP in Q2 2023, while external debt stood at 604% of GDP in June 2023. The current account deficit widened to 7.9% of GDP in 2023, after declining to 6.1% of GDP in 2021 from 10% of GDP in 2020 due to higher imports and related prices, while exports have yet to fully recover.
[This article was translated from its Greek original]
