OREANDA-NEWS. Fitch Ratings has affirmed Cyprus's Long-term foreign and local currency Issuer Default Ratings (IDRs) at 'B-' with a Positive Outlook. The issue ratings on Cyprus's senior unsecured foreign and local currency bonds have also been affirmed at 'B-'. The Country Ceiling has been raised to 'BB-' from 'B' and the Short-term foreign currency IDR has been affirmed at 'B'.

KEY RATING DRIVERS
Public debt, at around 107.1% of GDP in 2014, is more than double the 'B' category median of 47%. The high debt ratio reduces the fiscal scope to absorb any additional domestic or external shocks. However, the recent fiscal over-performance has improved the public debt dynamics. The general government debt to GDP ratio is expected to peak at just over 110% in 2015 and 2016 and will ease to around 90.7% by 2022. Fitch no longer assumes the full EUR10bn financial envelope of the EU-IMF programme will be used. The strong budget performance implies the buffers in the programme have grown close to EUR3bn (17% of GDP).

The underlying trend for public finances has been positive. The fiscal deficit in 2014 was 0.2% of GDP (8.8% of GDP including the one-off capital injections to the co-operative sector) compared with Fitch's forecast of 3.3% in October. The over-performance reflects a combination of higher tax revenues and lower than expected expenditure across most items. The strong budget execution should help keep future deficits lower. Fitch expects the fiscal deficits to average 0.8% from 2015 to 2018.

Despite the recent performance, the risks to EU-IMF programme implementation remain elevated. The government does not hold a majority in parliament, which has created obstacles to the timely passing of insolvency and foreclosure laws. There is a significant risk that privatisation plans required under the programme will not be fully implemented, leading to further delays to programme reviews.

The environment for Cyprus's banks remains challenging, especially with regards to weak asset quality. The stock of sector non-performing loans (NPLs) reached an exceptionally high 50% of gross loans at end-2014 from around 46% at end-April 2014. The ECB's Comprehensive Assessment found a shortfall in capital based on end-2013 data, but this had already been raised. The co-operative sector required EUR1.5bn of public injections in 2014, which was part of the EU-IMF programme envelope.

The removal of the remaining capital controls in April has led to the Country Ceiling being raised by three notches to 'BB-'. There has been an incremental relaxation of these controls over the past 18 months. Their easing and eventual removal has not led to any material financial or economic instability. Domestic banks' deposits increased in 2H14 and have remained broadly steady in the first four months of 2015.

As a country still in the midst of a post-crisis adjustment, Cyprus is among the most vulnerable eurozone sovereign to a disorderly Greek exit. The direct linkages between the two economies have been reduced in recent years and are not large. However, the impact on depositor and investor confidence is harder to gauge. Fitch's base case is that Greece will remain a member of the eurozone, but recognises that 'Grexit' is a material risk. Although a Greek exit would represent a significant shock to the eurozone that could spark a bout of financial market volatility and dent confidence, Fitch does not believe it would precipitate a systemic crisis like that seen in 2012, or another country's rapid exit.

Economic conditions in Cyprus remain challenging, with output forecast to decline by 0.8% in 2015, the fourth consecutive year of contraction. The GDP fall of 2.3% in 2014 is better than the 3% expected by Fitch in October. Private consumption has been more resilient than expected. Households have also been spending their savings, but there is uncertainty over the sustainability of this trend.

Near-term liquidity risk for the government is low. There are no major bond redemptions due until November 2015. Using the proceeds of market borrowing in 2014, the government has smoothed the maturity profile of its debt in 2016-2017, reducing refinancing risks. The passing of the insolvency law through parliament on 18 April should trigger the activation of the foreclosure law and pave the way for further official funding. EU-IMF programme reviews and funding had been suspended until the foreclosure law was implemented. The law should strengthen the foreclosure framework and address the high banking NPL problem.

RATING SENSITIVITIES
Future developments that may, individually or collectively, lead to positive rating action include:
- Further progress in implementing reforms contained in the EU-IMF programme.
- Further signs of a stabilisation in economic output and the banking sector, including a credible strategy to deal with the large NPL overhang.
- Improvements in export performance that help facilitate the rebalancing of the economy.
- A sustained track record of market access at affordable rates.

Future developments that may, individually or collectively, lead to negative rating action include:
- A weakening in the pace of fiscal consolidation, resulting in a less favourable trajectory of debt to GDP.
- A recession that is materially deeper or longer than assumed by Fitch or deflation which would have adverse consequences for public debt dynamics.
- Re-intensification of the banking crisis in Cyprus.
- A sustained period of deadlock with official creditors coupled with a lack of market access, putting pressure on government and banking system liquidity.

KEY ASSUMPTIONS
In its debt sensitivity analysis, Fitch assumes a primary surplus averaging 2.5% of GDP, trend real GDP growth averaging 1.4%, an average effective interest rate of 3.1% and GDP deflator inflation of 1.5%. On the basis of these assumptions, the debt-to-GDP ratio would peak at just over 110% in 2015 and 2016, and edge down slowly to 84.9% by 2024.

Debt-reducing operations specified in the EU-IMF programme such as privatisation (EUR1.4bn by 2018) and an asset swap for a government loan held by the Central Bank of Cyprus (EUR1bn) are not considered in Fitch's debt dynamics. Our projections also do not include the impact on growth of potential future gas reserves off the southern shores of Cyprus, the benefits from which are several years in the future, although now less speculative.

Fitch assumes that there will be no material escalation in developments between Russia and Ukraine that would lead to a significant external shock to the Cypriot economy. Tourism from Russia has been rising and Russians account for a sizeable share of foreign deposits in banks.

The European Central Bank's asset purchase programme should help underpin inflation expectations, and supports our base case that, in the context of a modest economic recovery, the eurozone will avoid prolonged deflation. Fitch also assumes gradual progress in deepening financial integration at the eurozone level and that eurozone governments will tighten fiscal policy over the medium term.