Fitch rating agency affirmed Cyprus’ long-term sovereign rating at “BBB-” with a stable outlook, citing high sovereign debt and a weak banking sector as the main challenges facing the island’s economy.
The agency said, Cyprus’ institutional strength as underlined in its per capita GDP and governance indicators and a record of robust economic growth and sound fiscal policy prior to the Covid-19 shock “are balanced by balance-sheet weaknesses, in particular high public debt and a weak banking sector.”
After a deep recession in 2020 with GDP contracting by 5.1%, the agency forecasts growth to recover to 3.5% in 2021 and 4.3% in 2022, broadly in line with the eurozone dynamics, and “driven by pent-up consumption demand.”
Fitch said recovery will likely gain momentum only in the second half of 2021, delayed by the recent wave of the pandemic, while there is high uncertainty regarding tourism in 2021, given its dependence on arrivals from western European countries where vaccination had a slow start and travel restrictions are expected to be lifted only gradually.
Furthermore, the agency said growth will be supported by EU Next Generation funds. Cyprus has EUR1.2 billion (5.5% of GDP) in grants from the Resilience and Recovery Facility for 2021-2026, with the government intending to front-load the spending of these funds, although plans are not finalised.
With regard to Cyprus’ fiscal balance, Fitch said that following persistent budget surpluses, Cyprus posted a deficit amounting to 5% in GDP in 2020 reflecting the pandemic-related expenditure and the decline in revenues due to the recession.
Fitch forecasts a budget deficit at 3.6% of GDP in 2021 and 2.5% in 2022, with the narrowing of the deficit expected to be mainly cyclical, as substantial structural fiscal consolidation is not expected until 2022.
Fitch also noted that Cyprus gross general government debt (GGGD) surged to 118% of GDP in 2020, marking a 24 percentage points (pp) increase, almost twice the 14pp increase in eurozone, partly due to fundamentals driven by the pandemic, as cash buffers were increased significantly to over 15% of GDP as the sovereign took advantage of benign financing conditions.
Fitch expects the debt ratio to decline by more than 10pp of GDP in 2021, predominantly as cash reserves are used for debt redemptions, while debt reduction “will be driven by policy tightening from 2022 and GGGD is forecast to fall below 100% in 2025.”
The agency highlighted that the large banking sector remains a weakness relative to `BBB` peers despite a significant fall in non-performing exposures (NPEs) during 2020.
NPEs declined to EUR4.7 billion (16.7% of total loans) by end-2020 from EUR8 billion at end-2019, due mainly to asset sales and write-offs by the two largest banks. The coverage ratio of the remaining NPE stock is 44%, in line with the eurozone average, the agency said.
Furthermore, Fitch said the government’s plans to facilitate the transfer of NPLs to the state-owned Asset Management Company, KEDIPES albeit it would further reduce NPLs is not accounted for in its forecasts, as plans are not yet finalized.
According to Fitch, the main factors that could lead to an upgrade are evidence that public debt/GDP will return to a firm downward trend over the medium term following the sharp increase in 2020, progress in asset-quality improvement in the banking sector, consistent with lower impairment charges and enhanced credit provision to the private sector and reduced vulnerability to external shocks.
The factors that could lead to a downgrade are associated with a failure to return public debt/GDP to a declining path, for example due to structural fiscal loosening, weak growth or materialisation of contingent liabilities and heightened risks in the banking sector, for example from substantial deterioration in asset quality, the agency added.