Standard & Poor’s Ratings Services has lowered its local currency sovereign credit ratings on the Republic of Cyprus to ‘A+/A-1’ from ‘AA-/A-1+’. At the same time, Standard & Poor’s affirmed its ‘A/A-1’ foreign currency sovereign credit ratings on Cyprus . The outlook is stable.
“The lowering of the local currency ratings reflects a deterioration of Cyprus ‘ medium-term fiscal prospects, due to weaker expenditure discipline and a marked increase in the general government debt burden, to 64% of GDP in 2003 from 59% in 2002,” says Standard & Poor’s credit analyst David Cooling.
Pressure on the government’s finances has increased sharply in 2003. From an initial general government deficit estimate equivalent to 2.3% of GDP, the government now anticipates a deficit of 5.4%. The widening fiscal imbalance reflects lower than anticipated growth in revenues due to tax reforms undertaken in 2002 and the weaker economic environment, and rapid growth in real primary expenditure, which is expected to average 12% in 2003. Assuming a sharp reduction in real primary expenditure growth, the deficit would narrow modestly to 4.6% of GDP in 2004 and 4.3% in 2005. At the same time, the general government debt burden is forecast to peak at 66% of GDP in 2004.
The prospect of EU accession in May 2004 continues to provide a policy anchor for structural reforms, including fiscal consolidation. The government, which aims to secure early membership of EMU, is expected to announce measures to consolidate the deficit later this month within the framework of the pre-accession economic programme. However, against the background of efforts to resolve Cyprus ‘ partition ahead of EU accession, as well as a slowdown in tourism, fiscal consolidation is likely to remain challenging.
“A sustained period of fiscal consolidation will be essential if Cyprus is to be among the first of the accession countries to join EMU,” says Cooling. “Membership of the Eurozone would effectively shield the republic from any balance of payments-related financial stress.”
External imbalances are expected to widen in 2003. The current account deficit is forecast to reach 5.9% of GDP. As a result, liquidity ratios are forecast to weaken in relation to similarly rated countries. Cyprus’ short-term external debt and gross external financing gap (current account deficit plus long-term principal repayments and short-term debt) at an estimated 148% of current account receipts (CARs) and 334% of reserves, respectively, in 2003 are substantial, reflecting non-resident deposits in the banking sector (estimated at 117% of CARs in 2003). Liquidity risks, however, are mitigated by banks’ holdings of liquid foreign assets, and long-standing relationships with non-residents.
“Failure to decisively address current trends in the fiscal deficit, or a further increase in balance of payments pressures, would undermine early participation in EMU and weaken the government’s credit standing,” says Cooling. “In line with their aspirations for early entry into EMU, policy-makers are expected to move to address the fiscal imbalance and stabilise the general government debt burden.”