Moody’s Upgrades Cyprus’ Government Bond Rating

16/11/2015
Moody's upgraded Cyprus' government bond rating by two notches to B1 from B3, on November 13. The outlook is stable while Cyprus’ short-term rating was affirmed at Not-Prime (NP).
 
The key drivers for the upgrade are:
1) The faster than expected economic recovery and the expectation of a continued more broad-based growth that extends beyond exports. Moreover, the economy has demonstrated resiliency to external risks, emanating from Greece (Caa3, stable) and Russia (Ba1, negative). After three years of contraction, real economic growth is expected to reach 1.2% in 2015 and 1.4% in 2016. Moreover, medium-term growth is expected to be more balanced, supported by a recovery in domestic demand helped by a stabilisation of the financial sector, improved competitiveness and the implementation of structural reforms.
2) Consistent outperformance on fiscal targets have led to a quicker reversal in the public debt ratio. A combination of better than expected growth and also strong budget execution underscore fiscal outperformance. Moody's expects fiscal discipline to continue post programme exit and through parliamentary elections next year. Under Moody's baseline scenario, the government debt burden will now reach below 100% by next year and around 80% of GDP by 2020. Moreover, Moody's expects the country to successfully exit the economic adjustment programme (financed by the European Stability Mechanism (ESM) (Aa1 stable) and the IMF) by mid-2016, further supported by the build-up of significant liquidity buffers.
Concurrently, Moody's has today raised the local-currency and foreign-currency bond ceilings to Baa1 from Baa3. The short-term foreign-currency bond ceiling has been raised to Prime-2 (P-2) from P-3. Additionally, the local-currency and foreign-currency deposit ceilings have been raised to Baa1 from B3 to reflect the full removal of capital controls. The short-term foreign-currency deposit ceiling has been raised to P-2 from NP.
 
RATINGS RATIONALE
The first driver of Moody's decision to upgrade Cyprus' rating to B1 is the faster than expected economic recovery, and the expectation that the export sector will continue to demonstrate resilience and will now be augmented by growth in domestic demand. Moreover, Moody's believes that structural reforms that improve competitiveness along with prospective structural reforms such as the reform of the public administration, privatisation and also the gradual strengthening of the financial sector will improve the sustainability of medium-term growth.
The more balanced growth pattern is also driven by the stabilisation in the financial sector, which has resulted in a slight uptick in corporate credit growth this year. While still very weak (with a weighted average Baseline Credit Assessment of caa3), the financial sector reflects stable liquidity trends and increasing prospects for a return to profitability. Importantly, deposits remain stable at a systemic level despite the full lifting of capital controls on 6 April 2015.
Moody's also expects that recent laws implemented in the financial sector, namely the insolvency and foreclosure framework, will support the gradual reduction of non-performing loans (NPLs) in the system, which are currently at a high 47% of total loans. That said, Moody's notes that both the corporate and household sectors continue to have high, albeit reducing debt burdens.
The second driver for the upgrade is the consistent outperformance of fiscal targets because of strong budget execution and better than expected growth performance. Consequently, Moody's expects that from this year onwards, public debt ratio will start to decline.
Since the onset of the structural adjustment programme, Cyprus's fiscal metrics have consistently exceeded the targets set by the EC and the IMF. Mainly expenditure-related measures (reducing public sector wages and benefits), 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. Strong fiscal discipline and budget execution has persisted since then, supporting the outperformance of fiscal targets. Importantly, the programme does not require additional fiscal measures for next year to meet the primary surplus target of 2.5% of GDP, implying a fiscally neutral policy can be implemented with no impact on growth.
Additionally, the rating agency notes that Cyprus regained market access last year and since then accumulated a substantial cash buffer. This buffer, as of today covers most of the country's repayment needs for 2016, preparing the country for a successful exit from the programme in March 2016 when the ESM funded programme finishes and May 2016 when the IMF programme ceases.
 
RATIONALE FOR STABLE OUTLOOK
The stable outlook on Cyprus's B1 rating reflects evenly balanced upside risks of improving growth and fiscal metrics with the downside risks of a still very large and fragile banking system with high NPLs, with the risk of contingent liabilities crystallising on the governments balance sheet still high.