Standard and Poor's Global Ratings has upgraded the outlook of the Cypriot economy to positive from stable, due to the continuation of the macroeconomic normalization, while at the same time confirming the long-term credit rating of Cyprus (in domestic and foreign currency) to "BBB" and A-2 for short-term assessment.
The rating agency emphasizes that the Cypriot economy is normalizing a decade after the financial crisis, the government is back to achieving fiscal surpluses, which will be maintained at 1.6% on average in the period 2023 - 202, nonperforming loans have fallen significantly from their crisis-era peak, and the economy's external sector deleveraging continues.
At the same time, it estimates that medium-term growth will be slightly below 3%, that net public debt will decrease to 52% of GDP by 2026, and that inflation levels are normalizing.
While vulnerabilities still exist on the economic, fiscal, and external front, the current trends support Cyprus' creditworthiness, underlines S and P, that notes that "the diversification of the technology sector and eventual natural gas production are likely to fuel the medium-term and long-term growth".
"We could raise the sovereign rating on Cyprus within the next 12-24 months if debt reduction were to continue on its current path, supported by tight expenditure control and consistent fiscal surpluses", the rating house notes. A similar action could also occur if the currently very elevated current account deficit were to shrink, easing concerns about Cypriot residents' external leverage, they add.
In addition, S and P could raise the rating if they were to observe improved stability in the financial system. As it notes, further declines in NPLs on the banking sector's balance sheet would signal such an improvement, and this could reduce the banking sector's contingent liability risk to the government, reinforce the effectiveness of monetary policy transmission, and strengthen banks' access to debt capital markets.
On the other hand, the agency states that they could revise the outlook to stable if, within the next 12-24 months, external short-term debt levels began rising again, reversing the current encouraging trend of deleveraging in the economy.
Rating pressure could also materialize if structural reform progress were to stall, creating meaningful delays to Cyprus' NextGenEU funding, they add.
According to S and P, the Cypriot economy continues to show resilience. Last year's real GDP growth (5.6% year on year) marked the sixth time expansion surpassed 5% in the past seven years. "Despite material exposure to Russia as well as the winding-down of the Cyprus Investment Programme, growth should settle at just below 3% over 2023-2026, on the back of effective relocation of foreign business into Cyprus, and a steady improvement in tourism", they note.
Authorities' aim to make Cyprus a digital hub is likely to further increase the dominance of services in an already a very open economy, according to the rating agency. Exports of services during 2022 were 5.7 times merchandise sales abroad. Last year's total external trade came to 159.3% of GDP from 124.2% in 2019 (and just 93.6% in 2012).
"We see the focus on creating a digital hub tailored to fintech and gaming as a critical component of the recent improvements. These could gradually usher in important diversification from Cyprus's bread-and-butter industry of tourism, which still makes up roughly 20% of GDP", says the agency in its press release.
According to S and P, one potential economic vulnerability is Cyprus' high reliance on imported oil and petroleum products. These made up just under 86% of gross energy supply in 2021, the highest of all EU member states. The recent discovery of significant offshore gas should help to reduce this dependency, as will the general trend in declining energy intensity of Cypriot GDP.
Nevertheless, although energy intensity is decreasing, the decline between 2021 and 2010 was less than the EU average; "this was somewhat surprising considering the services sector's rising share of GDP. One explanation could be the prominence of shipping in Cyprus' economy, which has complicated the calculation of national accounts, as well as external data", they note.
Growth rate, Inflation, fiscal surpluses, national debt
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S and P projects that growth will cool to a 2.4% in 2023, as sanctions take effect in earnest, financial conditions tighten, and household balance sheets erode from inflationary pressures.
Inflation levels are normalizing despite collective wage increases. The latest HICP inflation numbers show inflation fell to 2.4% in July, the third lowest in the euro area and within touching distance of the ECB's 2% target. Nonetheless, the increase of the Cost-of-Living Adjustment (CoLA), which will see public sector pay and professions with collective wage agreements rise by 66.7% of the prior year's inflation rate, could expose Cyprus to wage-price spiral dynamics, the agency notes.
Fiscal surpluses will likely endure even amid expenditure pressures, according to S and P. The government balance returned to positive territory last year, improving by 4.1% to reach a surplus of 2.1% of GDP. Although the public sector wage hike, increased defense spending, and green and digital transformation costs are likely to weigh on spending in the coming years, "we still expect the surplus to hold at 1.6% on average over 2023-2026".
S and P projects net debt will fall to 52% of GDP by 2026. Such consolidation would bring Cyprus significantly more in line with peers across the EU, where the agency estimates the median net debt will be 51% of GDP in the same year.
"Our estimate of Cyprus' net debt reflects sizable cash buffers of about pound 3 billion, which we assume will likely be maintained in the near term. Notably, Cyprus' debt costs remain affordable, with interest payments projected to occupy only 4.1% of government revenue on average over 2023-2026", according to the agency.
Banking sector
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S and P says that Cypriot banks are effectively cleaning up their balance sheets, affording them continued capital market access. NPLs stood at 9% of total loans as of April 2023. This marks a significant improvement from their peak of 49% in May 2016, with most progress seen in the larger systemic banks.
This has allowed systemic banks to tap capital markets in 2023, with several issuances compliant with additional tier 1 norms and the single resolution mechanism.
"Still, progress in balance sheet clean-up efforts has slowed in recent months as smaller banks face difficulties with transaction sizes. Further NPL reductions would support banks' and households' resilience to future shocks and limit contingent sovereign risks, in our view", the agency notes.
Source: Cyprus News Agency