From Standard & Poor’s:
Standard & Poor's Rating Services today lowered its long-term sovereign credit rating on the Republic of Cyprus to 'BBB' from 'BBB+'. At the same time, we lowered the short-term sovereign credit rating on Cyprus to 'A-3' from 'A-2'. The long-term rating remains on CreditWatch with negative implications, where it was initially placed on Aug. 12, 2011. We are removing the short-term rating from CreditWatch Negative. The transfer and convertibility assessment for Cyprus remains 'AAA', the same as for all members of the European Economic and Monetary Union (EMU).
In our opinion, the contingent liabilities posed to the Cypriot government by the Cypriot banking system's exposure to Greece continue to weigh heavily on the ratings on Cyprus. We believe that a Greek default scenario with private sector involvement (PSI) or "haircuts" higher than previously agreed by commercial creditors would necessitate the recapitalization of some domestic banking institutions, either through a public offering or a government capital injection. We also believe the effect of a Greek government default could reverberate through Cyprus' economy in the form of private-sector funding costs increasing beyond our previous expectations, thereby reducing investment and overall domestic demand. Furthermore, weaker economic growth could worsen the Cypriot government's debt dynamics and reduce the willingness of its political leaders to press forward with fiscal and labor market reforms.
We estimate the exposure of Cypriot banks to Greek debt (sovereign, corporate, and bank combined) at about 165% of Cyprus' GDP. Depending on the PSI levels in any forthcoming Greek sovereign debt exchange, this could result in bank recapitalization needs of up to 10% of GDP. Some domestic banking institutions wrote-down their holdings of eligible Greek government bonds by 21% earlier in 2011, and increased their capital levels; system-wide Tier 1 capital adequacy was 11.2% as of June 2011. However, with greater PSI now envisioned for a Greek government debt restructuring and with uncertainty in equity markets, Cyprus' domestic banks may, in our opinion, turn to official sources for fresh capital to maintain market confidence.
On Aug. 26, 2011, the Cypriot government adopted and implemented several measures aimed at reducing its fiscal deficit. The measures totaled €104 million or 0.6% of GDP in 2011, and €261 million or 1.3% of GDP in 2012, short of the €150 million or 0.8% of GDP and €650 million or 3.5% of GDP needed to reach the then deficit targets of 5.5% in 2011 and 2% in 2012. Since this time, no new measures have been implemented. Additionally, the government has revised its 2011 deficit target to 6.5% of GDP, and 2012 target to 2.8%.
The bulk of the measures contemplated by Cyprus' government for 2012--such as saving an estimated €200 million through revised social spending targets, postponing the first round of 2012 wage increases (relating to cost of living adjustments) until 2014, and proposing a 2% increase in VAT to 17%--have been presented to parliament as part of, or alongside, the 2012 proposed budget. We view the full implementation of these measures as unclear because of opposition from organized labor and other social partners.
In our base-case scenario, we expect real GDP growth to remain flat until 2013 as the external environment continues to deteriorate. We expect this will drag on government revenues as well as delay important structural improvements to Cyprus' public finances, and lead to fiscal deficits of nearly 7% of GDP in 2011 and about 4% in 2012. Faced with maturing debt of nearly 8% of GDP in first-quarter 2012, Cyprus' government is, in our view, likely to agree to a €2.5 billion (14% of GDP) bilateral loan agreement with the Russian government. This could help alleviate funding pressures well into 2012, in our opinion. There could also be sizable one-off revenues from the licensing of natural gas exploration blocks, which could, all other things being equal, lead us to revise downward our current fiscal deficit projections. In our opinion, however, these important but temporary revenues would not structurally improve Cyprus' public finances. Moreover, we believe such one-off agreements could reduce the willingness of social partners to agree to the planned fiscal consolidation measures.
We note heightened geopolitical tensions in the eastern Mediterranean regarding the exploration of potential natural gas reserves in Cyprus' exclusive economic zone; this informs part of our political assessment of Cyprus' sovereign rating. However, we have not taken into account the potential effect that discovery and extraction of any gas reserves might have on the Cypriot economy and public revenues. Not only are key details about any gas reserves yet to be confirmed, but we forecast that commercial production would likely not begin until after the three-year horizon our ratings address.