STANDARD & Poor’s Ratings Services said today that it lowered its long-term sovereign credit rating on the Republic of Cyprus to ‘B’ from ‘BB’. At the same time, it affirmed its short-term sovereign credit rating on Cyprus at ‘B’.
The long-term rating remains on CreditWatch with negative implications, where it was initially placed on Aug. 1, 2012.
In its statement, S&P said “The downgrade reflects our view that Cyprus’ creditworthiness has deteriorated since the last downgrade on Aug. 2, 2012, as the government has not yet negotiated a support package, while external and fiscal risks have risen.”
We believe that electoral considerations ahead of the presidential poll, scheduled for February of 2013, have contributed to policy inertia. This is in the face of a severe banking crisis, partly triggered by Cypriot banks’ involvement in Greek debt restructuring in early 2012 (private sector involvement) but made worse by the deterioration in banks’ domestic lending books, and the government’s fiscal inaction.”
We see only limited progress by the government in agreeing to a critical loan program with the Troika”.
We still expect a support package to total amounts in line with our earlier estimates over an extended period from 2012 to 2015, but we note the considerable uncertainties surrounding the estimates of the banking sector’s potential capital needs. However, we believe that the results of a deeper government diagnostics exercise will likely reveal further capital needs in the Cypriot banking system, especially if the definition of nonperforming loans for the cooperative banking sector is aligned with European norms. Extra capital needs related to credit losses on the Greek loan books of Cyprus Popular Bank and Bank of Cyprus are also likely to arise, depending on economic developments in Greece”.
In our view, it is highly likely that the burden of recapitalizing the banks will fall on the government’s balance sheet, increasing the risk of a government debt rescheduling. Given the significant constraints on Cyprus’ fiscal flexibility, we view the government’s potential debt burden as difficult to service. It could reach 130% of GDP by the end of 2013, the upper end of our July 2012 estimate”.
In our opinion, Cyprus’ commercial banks–or the government itself–could be forced to reschedule their debt in order to meet the terms of an official lending program. Potential loans from the ESM could be senior to holders of Cypriot debt, and we understand it is somewhat uncertain whether this could trigger the acceleration of debt repayment issued under the government’s medium term notes (EMTN) program according to the provisions of the EMTN transaction documents”.
This could significantly weaken confidence in Cyprus’ financial system; the banking system currently holds nonresident deposits valued at around 140% of GDP”.
It remains our base case that the government will reach agreement with the Troika. This agreement could, in our view, possibly involve a bilateral component from the Russian Federation. We also understand that funds coming from the Troika should be sufficient to meet Cyprus’ external and fiscal needs”.
Given Cyprus’ increasing debt overhang and weak first-half 2012 financial indicators, we have lowered our annual GDP per capita growth expectations to around minus 2% on average for 2012-2014. Included in these expectations is our assumption of a consolidation, mainly on the expenditure side, of about 2% of GDP per year over the next three years, further depressing public consumption growth. Moreover, we project that very depressed credit growth will weigh on weak private consumption and investment, which we expect will contract significantly”.
The CreditWatch placement reflects our view of the potential for another downgrade if Cyprus’ external and fiscal financing pressures escalate. We see at least a one-in-two chance that we could lower the rating again if official assistance is not forthcoming. We could also lower the ratings if we believe the government is not able to fulfil the conditions of a Troika program”.
On the other hand, the ratings could stabilize at their current levels if we see that a program is quickly concluded and if growth prospects, government debt, and external funding needs begin to stabilize”.