Bangkok--30 Jul--Standard & Poor's
Standard & Poor's Ratings Services today lowered its long-term sovereign credit rating on the Republic of Cyprus to 'BBB+' from 'A-'. At the same time, we affirmed the short-term sovereign credit rating at 'A-2'. The outlook on the ratings remains negative. The transfer and convertibility (T&C) assessment for Cyprus continues to be 'AAA', the same as for all members of the European Economic and Monetary Union (EMU).
Despite ongoing talks about substantial consolidation measures, we believe the Cypriot government will struggle to meet its 2011 general government deficit target of less than 4% of GDP, and its 2012 target of 2%. This, in turn, will likely increase the government's debt burden, which we currently expect will be 80% of GDP at the end of 2011 (this figure includes the government's ?2.79 billon three-year repo facility, which is due to expire by the end of November 2012). Such a substantial rise in general government debt is likely to reduce the Cypriot government's capacity to back-stop its domestic banking sector, which in our view is vulnerable to the potential restructuring of government debt in Greece (see "Long-Term Sovereign Rating On Greece Cut To 'CC' On Likely Default; Outlook Negative," published July 27, 2011)
Between 2008 and 2010, Cyprus' general government budgetary position shifted from a surplus of just under 1% of GDP to a deficit of 5.3% of GDP. Government personnel expenditures continue to make up a high proportion of total spending (25%). Prospects for passing personnel and benefit cuts through parliament are uncertain, however, not least due to the influence of public sector unions. Reforms aimed at introducing public-sector workers' contributions to their pensions and increasing the age of retirement are also facing delays.
The Cypriot government's struggle to reduce current expenditures has slowed the pace of external rebalancing as the fiscal impulse explains a significant component of Cyprus' narrowing-but-still-substantial current account deficit. We forecast the current account deficit at just below 7% of GDP at end-2011 (and possibly higher due to the impact of the explosion at Vasilikos power station on energy and capital imports) and more than 10% of annual current account receipts.
The uncertain fiscal adjustment raises questions about the government's capacity to support a large banking system with substantial exposure to both Cyprus and Greece. The Cypriot banking sector's loans to Greek customers and holdings of Greek sovereign and bank debt are alone equivalent to more than 160% of Cyprus' GDP, while Cypriot banks' (and subsidiaries of foreign parent banks, including Greek and Russian financial institutions) domestic claims are nearly 280% of Cyprus' GDP. Although the Cypriot banking system is, in our view, well capitalized, we anticipate that potential losses by Cypriot banks on their holdings of Greek sovereign and Greek bank debt may reduce current capital levels (see "Long-Term Sovereign Rating On Greece Cut To 'CC' On Likely Default; Outlook Negative," published July 27, 2011). Our baseline expectation is that the Cypriot government will not need to recapitalize the banks in the near future, but the ongoing uncertainty in the external environment increases the risk of this eventuality.
In our view, these risks weigh on Cypriot growth prospects. Our 2% baseline medium-term GDP growth expectation is already considerably lower than Cyprus' 2002-2007 pre-crisis average growth of 3.5%. Any further deterioration in Greece's creditworthiness could further depress Cyprus' growth prospects by indirectly tightening domestic credit conditions--as Cypriot banks are likely to adopt a more defensive strategy in expectation of potential additional capital needs. Moreover, the Vasilikos power station explosion will directly and indirectly subtract from growth, due to lower energy consumption and higher imports.
The negative outlook reflects our view of the likelihood of a downgrade if substantial expenditure cuts fail to materialize, or if the Cypriot government is required to recapitalize the commercial banking system. In contrast, should commercial banks strengthen their capital bases further without public assistance, amid improving asset quality and credible fiscal consolidation allowing for a reduction in general government debt to GDP, we would likely revise the outlook to stable.
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