Fitch Ratings is providing further comment on the rating actions it took earlier today on the Republic of Cyprus (Cyprus), where its Long-term Issuer Default Rating (IDR) was downgraded to 'BBB-' from 'BBB', Negative Outlook, and its Short-term IDR was affirmed at 'F3'.
The downgrade follows the Rating Watch Negative (RWN) placed on the sovereign ratings of Cyprus and five other Euro Area Member States (EAMS) on 16 December 2011. The RWN was initiated in response to concern over the lack of clarity on the ultimate structure of a fundamentally reformed Economic and Monetary Union; the risk of self-fulfilling liquidity and even solvency crises in the absence of a fully-credible financial 'firewall' against contagion; and the significant negative external shock to the region's economy from the prolonged nature of the eurozone systemic crisis.
Whilst Fitch has reduced the score assigned to capture financing flexibility in its assessment of the credit profile of those eurozone sovereigns that have large fiscal financing needs and significant financial/economic imbalances, in Cyprus's case this was already reflected in its low investment-grade ratings. Instead, the one-notch downgrade of the sovereign rating mainly reflects the Cypriot banks' large capital need in light of the Greek debt restructuring expected this quarter.
Fitch estimates that the amount needed to recapitalise the three largest banks to a Tier 1 ratio of 10% following a 50% haircut on Greek government bonds (GGB) amounts to EUR0.9bn or 5% of GDP. A 70% haircut would require EUR1.7bn or 9.9% of GDP. The now higher likelihood of a haircut in the 50%-70% range, compared with Fitch's view in August, when a 20%-30% haircut was the agency's baseline, is the primary reason for the rating downgrade.
While two of the three largest Cypriot banks, Bank of Cyprus ('BBB-'/RWN) and Hellenic Bank ('BBB-'/RWN) have already impaired their GGB exposures by 50% of nominal value, and consequently reduced their exposure, further pressure on banks' capital is expected if the final GGB haircut is higher, notably in the case of Marfin Popular Bank ('BBB-'/RWN). In addition, Fitch believes internal capital generation will be weighed down by continuing asset quality problems in their Greek loan portfolios, and to a lesser extent Cypriot loan books.
As the Cypriot banks are large holders of Greek government bonds, the potential capital requirements will be correspondingly high. Fitch believes it is highly uncertain whether the necessary funds will be found in the private sector or whether government assistance for certain institutions will instead be required to meet such capital requirements. This would increase the government debt/GDP ratio and might require external assistance.
Whilst Cypriot banking sector exposure to Greece is significant the domestic banks have already written off a proportion of Greek government bonds. Approximately one third of the banking system's assets are booked as Greek exposure, including not only sovereign and bank bonds but substantial Cypriot bank loans to Greek companies and households.
The recorded 10-year yields on sovereign debt remain high at over 12% and the market has become shallow and illiquid. The rating reflects the loss of access to international markets, albeit the government is able to raise some funds on the domestic market (e.g. a three year bond was successfully sold in the local market earlier this month at a yield of 6.89%). Fitch also notes that despite the government's evident reluctance to approach its fellow EU members or the IMF for assistance, this is likely to be available, albeit with policy conditionality.
Since its last review of Cyprus in August 2011, the government has passed three consolidation packages and expects to bring the deficit down to 2.5% in 2012 from 6% of GDP in 2011. While Fitch does not see this target as realistic, forecasting instead at least 3%, the underlying fiscal stance is encouraging as is the fact that the measures were passed by a clear majority in parliament. In broad terms the package is designed to restrain public sector wage costs and employee numbers, cut welfare costs by a better targeting of recipients and raising taxes, including a rise in VAT from 15% to 17%.
The government has also effectively pre-funded the 2012 annual borrowing requirement mainly by negotiating a EUR2.5bn loan from the Russian government. This will permit the repayment of over EUR1bn in debt falling due in the first two months of 2012 which had been a consideration in Fitch's previous sovereign downgrade in August 2011. The government however remains unable to access the international debt markets. Nor is there any guarantee that further bilateral inter-governmental loans will be forthcoming.
An important outstanding policy issue is the future of COLA, the official wage adjustment to inflation process. The government has pledged to introduce reforms to the system, blamed by many for excessive wage rises in the past, by mid year. The COLA system has been much valued by the powerful trade union movement and has previously proved immune to reform or abolition. The latest round of negotiations will provide one early test of the government's determination to reform the functioning of the economy.
The Negative Outlook primarily reflects the risk that the eurozone crisis could intensify further. Triggers for further negative rating action would include failure to implement fiscal consolidation, a failure to secure sufficient and timely external financial support if needed, or a major further deterioration in the banking sector outlook, such as capital flight via bank deposit outflows. Successful implementation of the 2012 and 2013 budgets, and the attainment of private sector recapitalisation funds by the banks and their eventual return to normal profitability and funding would help to stabilise the Outlook.
