.jpg)
- We believe that in the absence of a credible alternative source of capital and fiscal financing, the risk of a disorderly credit event is rising.
- We are lowering our long-term sovereign credit rating on Cyprus to 'CCC' from 'CCC+'.
- The outlook is negative.
Standard & Poor's Ratings Services today said it lowered its long-term sovereign credit rating on the Republic of Cyprus to 'CCC' from 'CCC+'. The outlook is negative. We also affirmed our 'C' short-term sovereign credit rating on Cyprus.
The downgrade mainly reflects our view of the acute problems in Cyprus' banking sector. Since early 2012, Cyprus' domestic banks have repeatedly suffered losses because of write-downs on their holdings of Greek government bonds and credit losses on their Greek and domestic private-sector loans. Our expectation is that the two largest Cypriot commercial lenders will together require €10 billion in capital injections. On March 16, the Eurogroup (that is, the meeting of the finance ministers of the eurozone) offered Cyprus' government a three-year financial assistance package to cover a portion of this capital support for Cyprus' banks, on top of financing for sovereign debt redemptions and expected budgetary deficits. A key condition attached to the offer of €10 billion of funding from the European Stability Mechanism was a proposed financial stability levy on all resident and nonresident bank depositors. The levy was designed to raise €5.8 billion of the €10 billion in additional capital for Cyprus' two largest domestic commercial banks, on top of an estimated €1.2 billion in write-downs of the banks' subordinated bonded debt obligations.
Given that the assets of Cyprus' indigenous banking sector are more than 5x GDP, we consider Cyprus' credit standing to be inextricably linked to its banking system. Neither the bank shareholders nor Cyprus' government appear able on their own to meet the banks' pressing capital needs. In the absence of foreign private or official capital injections into the Cypriot banks, we see few means to recapitalize the distressed portion of the system without converting bank liabilities, including deposits, into equity claims. However, political resistance to haircutting depositors was clearly signaled on March 19 by the Cypriot parliament rejecting the Eurogroup proposal, without a single vote in its favor.
Despite the parliamentary vote, we believe the Eurogroup is resolved to reach an agreement with Cypriot authorities on a credible financing package. At the same time, in light of building economic and financial stability pressures, the terms of any support package are likely to be unpopular and challenging to implement in the context of a severe, protracted economic downturn and an extended bank holiday. As a consequence, we believe that risks of a sovereign default are rising. We estimate the government's remaining 2013 gross borrowing requirement at 18% of GDP.
We expect that over the next few days Cyprus and the Eurogroup or other partners could reach an alternative agreement. The European Central Bank (ECB) confirmed on Tuesday evening that it would continue to approve the extension of Emergency Liquidity Assistance (ELA) by the Central Bank of Cyprus to Cyprus' banks as needed, subject to internal rules. The current outstanding ELA advances total €9.1 billion (53% of GDP). Our baseline expectation is that Cyprus will remain a member of the European Economic and Monetary Union.
Nevertheless, risks remain that renewed deposit flight could exacerbate the economic downturn, create the need for the imposition of capital controls, and increase the requirement for additional bank support. Failure by the government to broker an agreement with its European partners in a timely manner could lead the ECB to demand ELA repayment, which could put Cyprus' payment system at risk. The possibility of a write-down of the deposit base has, moreover, led us to revise down our 2013 GDP forecast to -6%, given that the negative income effect of deposit levies is likely to weaken demand over the forecast horizon. This GDP projection is subject to considerable uncertainties, however, depending on the resolution of Cyprus' financial difficulties and the future of its banking and business services sectors. Weaker GDP performance implies a higher debt-to-GDP burden. However, alternative sources of funding appear to us to be limited, particularly since we understand that the Social Security Funds are already fully invested in government liabilities, though there may be some latitude for the government to tap funds held in the private pension system.
We would likely lower the rating if Cyprus' government fails to obtain a financing program soon. If it secures a program, we could also lower the ratings later this year if we believe the government is unable to fulfill the program's conditions. The ratings could stabilize at the current levels with the government's 2013 financing requirement in place and with an agreed-upon bank recapitalization plan.
