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Fitch Downgrades Cyprus to 'BB-', Outlook Negative

November 22, 2012 Fitch Ratings
Fitch Ratings has downgraded the Republic of Cyprus's Long-term foreign and local currency Issuer Default Rating (IDRs) to 'BB-' from 'BB+'. The Short-term IDR has been affirmed at 'B'. The Outlook on the Long-term IDRs is Negative. Fitch has simultaneously affirmed the Country Ceiling for Cyprus at 'AAA'.
RATING RATIONALE
The downgrade of Cyprus's sovereign ratings reflects the materially weaker macroeconomic outlook, a fiscal budget that has significantly underperformed expectations and the continued high level of uncertainty over the costs associated with bank recapitalisation. The delay in negotiating official support has contributed to the deteriorating economic conditions and raised uncertainties about public sector reform and the correction of macroeconomic imbalances. The government's short-term financing flexibility has also been materially reduced with the its current dependence on bank financing to meet its funding needs.

ECONOMIC & FISCAL OUTLOOK
The Cypriot economy slipped into its second recession in less than two years in summer 2011 with the weakness intensifying more than expected into the current year. With the exception of tourism, all sectors contracted in the third quarter to September 2012. The economy is on course to shrink by more than 2% this year after growing by 0.5% in 2011. The contraction is deeper than forecast in Fitch's review of the rating in June 2012 and Cyprus will remain in recession into 2014.

A period of adjustment in the public and private sector, which is also highly indebted, will put significant pressure on domestic demand. Support from the external sector will be limited by reduced competitiveness and weak prospects for key trading partners. Greece is the country's biggest export market, accounting for almost a quarter of total exports in 2011. Persistent macro imbalances also mean medium-term growth prospects are anaemic. Material downside risks to the outlook remain.

Cyprus's fiscal position has deteriorated significantly during 2012. In the April Stability Programme, the government's stated goal was to reduce the fiscal deficit to 2.6% of GDP for this year from 6.3% in 2011. Data from the Cyprus Ministry of Finance show that for the nine months to September the fiscal shortfall already exceeded the level for the same period last year. Fitch expects the deficit to be over 5% for 2012. This is despite austerity measures, including wage freezes and an increase in VAT by 2 percentage points to 17%. The depressed macroeconomic environment dampened receipts, while any expenditure savings have been offset by an increase in interest and pension expenditure. The weaker growth outlook will increase the challenge of reducing the fiscal deficit and the public debt ratio, which is set to remain substantially higher than before the recession.

In Fitch's baseline scenario, general government debt to GDP will peak around 120% in 2014, up from 71.1% in 2011. The bulk of the projected increase reflects Fitch's assessment that the Cypriot banks will require further significant capital injections. The three main Cypriot banks will need at least around a further EUR4bn (22% of GDP) in addition to the EUR1.8bn already injected into Cyprus Popular Bank in 2012. There are uncertainties over the capital shortfall of Cypriot cooperative banks and the overall banking system's recapitalisation costs could be substantially higher under more stressed scenarios. The capital backstop facility that will be set under a potential Troika adjustment programme will likely include a buffer to cover any risk of excess capital requirements over expectations with the intent to secure confidence and stability in the banking system.

KEY ASSUMPTIONS AND SENSITIVITIES
Negotiations with the Troika have lasted longer than expected despite recent progress on setting key capital ratios for banks and the system's supervision. A request for official aid by Cyprus was made in late June. February's presidential election risks further delays. However, the agency's ratings are predicated on Fitch's expectation that the Cypriot authorities will reach agreement with the Troika on an official financing programme.

The lack of a clear and credible programme to tackle the fiscal and macroeconomic challenges has negatively impacted business and investor confidence. The continuation of an unstable environment could translate into greater fiscal and banking costs for the government. The delays have also raised concerns about the prospects for fiscal and economic reform. The government's disagreements with the Troika, also mostly supported by the main opposition parties, extend to the size of the capital requirement for the banking sector, the size of cuts in public spending, privatisation of state-owned enterprises and reforms of the wage indexation system. Resistance to reforms is a key downside risk to the medium-term fiscal and economic outlook.

The government is possibly able to fund itself for several months until a EUR1.4bn bond redemption is due in June 2013. Refinancing requirements are low into the first quarter of next year and are currently being met through T-bills issued to banks. However, recourse to such funding reduces the government's ability to respond to adverse shocks and materially increases rollover risks. This is despite cash deposits and government reserves in state-owned enterprises. At the end of 2011 Cyprus received liquidity support from the government of Russia, which financed most of the funding requirements for the current year. Public statements suggest that a decision by Russia on Cyprus's request for further support is unlikely in the near term.

NEGATIVE OUTLOOK
The Negative Outlook primarily reflects the risks associated with bank recapitalisation costs, the short-term financing situation, progress towards a deficit and debt reduction programme and intensification of the eurozone crisis, notably further contagion from Greece. A further downgrade could be triggered if the capital shortfall in the banking sector is materially larger than current Fitch estimates, government's access to short-term funding becomes restricted or a lack of progress in negotiations with Troika puts at risk a timely adjustment programme to address the fiscal and macroeconomic challenges of Cyprus.

Progress on deficit reduction, recapitalisation of the banking sector and reform to address medium-term challenges arising from an aging population and low productivity growth would support a stabilisation of the rating. An agreement with the Troika on a bailout programme that delineates the burden-sharing arrangements for the Cypriot banks, which is not Fitch's baseline assumption, would be a further stabilising factor for the rating.
Company — Cyprus
  • Full name
    Republic of Cyprus
  • Registration country
    Cyprus