TORONTO – DBRS Ratings GmbH (Morningstar DBRS) confirmed the Republic of Cyprus’ Long-Term Foreign and Local Currency – Issuer Ratings at BBB (high). The trend on the Long-Term ratings has been changed to Positive from Stable. At the same time, Morningstar DBRS confirmed the Republic of Cyprus’ Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trend on all Short-Term ratings remains Stable.

KEY CREDIT RATING CONSIDERATIONS

The Positive trend reflects Morningstar DBRS’ view that public debt metrics are likely to continue to improve. The general government debt-to-GDP ratio decreased from 99.3% in 2021 to 77.4% in 2023. Looking ahead, the European Commission (EC) forecasts general government debt to decline further to 65.4% of GDP in 2025 on the back of strong economic growth and fiscal surpluses. Economic growth is likely to continue to benefit from robust private consumption, rising service exports and strong construction investment over the next few years. The EC forecasts real GDP in Cyprus to grow by an average of 2.9% in 2024 and 2025, compared to a growth rate of 1.1% for the Euro Area. Favorable growth and employment developments, in turn, are projected to bolster tax revenues and social security contributions. Strong revenue growth has been a key driver of fiscal surpluses in recent years. During the first seven months of 2024, general government revenues grew by a large 14.2% on a year-on-year basis, driven by higher income taxes and social contributions which clearly exceeded the 9.4% increase in public spending. Morningstar DBRS takes the view that government accounts are likely to continue to benefit from strong, albeit decelerating, revenue growth which will offset moderate spending pressures arising from rising public wages, aging-related expenditure and the roll-out of the mortgage-to-rent scheme. The government’s stability program from April 2024 forecasts the general government budget surplus at 2.9% of GDP in 2024 and at 2.8% in 2025.

Cyprus’ BBB (high) ratings are supported by a stable political environment, the government’s sound fiscal and economic policies in recent years, and a moderate interest burden. Furthermore, although governance indicators have weakened over the past years, Morningstar DBRS continues to view the country’s EU membership as an important anchor for institutional quality. On the other hand, the credit ratings of Cyprus continue to be constrained by the small size of its service-driven economy, which renders it vulnerable to external shocks. Cyprus also faces significant challenges due to a legacy stock of NPLs in the banking sector and the economy’s still comparatively low level of labour productivity.

CREDIT RATING DRIVERS

The credit ratings could be upgraded if one or a combination of the following occur: (1) sustained economic growth and a lasting strong fiscal performance leading to a material reduction in the public debt ratio; (2) evidence of increased economic resiliency and rising labour productivity levels.

The Positive trend could be returned to Stable if the downward path in the public debt ratio is less durable than anticipated. The credit ratings could be downgraded if one or a combination of the following occur: (1) a significant deterioration in the public debt trajectory, potentially due to a prolonged period of weak growth or rising budgetary pressures; (2) the materialisation of large contingent liabilities particularly from the large domestic banking sector.

CREDIT RATING RATIONALE

Economic Growth Remains Comparatively Strong

The Cypriot economy continued to grow at a comparatively strong pace in recent months. Real GDP expanded by 3.5% on a year-on-year basis during the first half of 2024 compared to a growth rate of just 0.5% for the entire Euro area during the same time period. Growth was driven by robust private consumption, underpinned by a catch-up in real wages and solid employment growth on the back of rising inflows of foreign labour. Furthermore, service exports rose and domestic investment strengthened markedly particularly with regard to residential and non-residential construction. On the production side, growth was bolstered by a further rebound in tourist arrivals, a continued expansion of information and communications technology (ICT) and construction. In addition, business services recovered from a slump in spring 2023 which had resulted from a step-up of financial sanctions on Russia. The economic outlook remains favorable. Private consumption is likely to benefit from further, albeit decelerating, growth in real wages and a continued increase in employment levels. Furthermore, investment activity is projected to be supported by several major investment projects particularly in the tourism and residential real estate sectors and rising inflows of Next Generation EU funds. In June 2024, the Central Bank of Cyprus (CBC) forecasted real GDP to expand by 3.0% in 2024 and by 3.1% in 2025 on an annual basis. In terms of 2024, Morningstar DBRS notes that the annual growth rate is likely to be higher than projected in June given the strong economic growth dynamics during the first half of this year. At the same time, the growth outlook is exposed to important downside risks such as an escalation of the military conflict in Ukraine and a prolonged disruption in trade in the Red Sea.

In general, the ratings of Cyprus continue to be constrained by the small size of its service-driven economy, which renders it vulnerable to external shocks. The most important industries are trade, tourism, financial and business services and real estate. In addition, gross value added in the ICT sector has increased sharply since 2016 as several foreign ICT companies relocated operations to Cyprus not least as a result of different policy measures (e.g. tax incentives). While, however, the share of the ICT sector at total gross value added almost doubled from 4.8% to 9.4% between 2015 and 2023, the increase of employment in the ICT sector was much less pronounced, accounting for 3.6% of total domestic employment in 2023, up from a share of 2.7% in 2015. Labour productivity levels of the economy remain below the EU average, notwithstanding strong economic growth dynamics in recent years, which can partly be ascribed to the important role of labour-intensive industries such as tourism. According to Eurostat, the level of nominal GDP per person employed in Cyprus amounted to only 89.2% of the EU27 average in 2023.

More information is available online: https://dbrs.morningstar.com.