By George Theocharides
The first long-awaited upgrade of the Cyprus economy by the rating agencies for this autumn has finally arrived, with the recent upgrade from Standard & Poor’s (S&P) by one notch (from BB- to BB).
Now we are only two notches away from the investment-grade (IG) market, which is a far cry from the ratings that we had back in 2013 during the banking crisis (CCC+), five notches below the latest rating. We are still part of the ‘junk’ (high-yield) sector, but if things go well or as planned, then during 2017 we might return back to the ‘elite club’ of the countries that belong to the IG market.
I also expect that the other two important rating agencies (Moody’s and Fitch) will upgrade the country soon. The rating by Moody’s is B1 (4 notches away from the IG market), while for Fitch it’s B+ (again, 4 notches away from the IG market).
Why the latest upgrade?
Looking at the recent history of ratings, Cyprus first joined the high risk/high return ‘junk’ market on January 13, 2012, with the downgrade by S&P. Within the subsequent few months, the rest of the main rating agencies also downgraded us to the ‘junk’ sector. Further downgrades took place until 2013, until we stabilised the economic situation and we started having gradual upgrades.
Why did we have the latest upgrade? According to S&P the reason for the upgrade is the improvement in the general economic condition of the country. The real rate of GDP growth will be higher than what was originally expected (2.7% expected for this year, and projected at around 2.5% for the period 2017-2019), while the budget account will be balanced or even with a surplus in the coming years, which can lead to declining levels of public debt.
Furthermore, the unemployment rate is expected to fall below 12% by 2018, increasing households’ disposable income and private consumption. In terms of the banking sector, the situation has stabilised and, although the level of non-performing loans (NPLs) is still very high, it is gradually declining through the restructuring process.
We would expect further upgrades in the future as long as the rate of reduction of the NPLs accelerates, the government implements the structural reforms (public service, health care, privatisations, etc.), while a possible reunification of the island can lead to accelerated growth rates, despite the initial challenges.
I would add though that another reason for the upgrade is the correct decision taken by the government to test the markets in June, right after our exit from the Memorandum of Understanding (MoU)—the bailout programme—with a successful 7-year issuance of a government note. S&P has now followed the market with the upgrade. Note here that in some cases rating agencies follow the market; in other cases the markets show us the way.
Are the upgrades and return to IG market important? The answer is simply yes. One obvious reason is the fact that a reputable and important organisation gave a vote of confidence for the Cyprus economy. These upgrades can be the driving force for more investment in the island (whether this is for buying government debt, or investing in private projects).
An upgrade implies lower risk for the investors, therefore this translates into a lower cost of financing for the country, which can lead to a reduction in the level of public debt. Right now, the yield on the 10-year government note that expires in November 2025 is at 3.6%, which is at historically low levels, but has room for a lot of improvement. For example, Germany’s AAA-rated 10-year notes provide a yield of 0%, while the five-year note provides a negative 0.5% annual return.
Going back to the IG market will also provide the added advantage of joining the ‘elite club’ of the IG-rated countries, which increases the pool of prospective investors, while at the same time it gives us the chance to return back to the Quantitative Easing (QE) programme of the European Central Bank (ECB). Being part of the QE programme can lead to higher levels of liquidity in the domestic market, while it will further push downwards the yield of our government bonds.
Concluding, I would argue that these rating upgrades and the return to the IG market are necessary (but not sufficient) if we want to say finally that the crisis is well and truly behind us.
The writer is Associate Professor of Finance at Cyprus International Institute of Management (CIIM)