Thursday, June 20 2024

Cyprus: Covid-19 reverses growth, fiscal consolidation for now; banking vulnerabilities a key risk

Covid-19 will push Cyprus into deep recession and erode public finances near term. Still, Scope expects Cyprus’s public debt-to-GDP to return to a downward trajectory from 2021 with banking sector vulnerabilities a key risk to growth and fiscal outlooks.

After years of robust growth, Cyprus’s (BBB-/Stable) GDP will contract sharply in 2020. This reflects stringent containment measures and the vulnerability of the country’s core economic sectors – tourism, real estate, financial and business services – to heightened global risk, which is only partly offset by the country’s strong growth momentum entering the crisis. Scope is forecasting a contraction of around 9%: in line with the euro area (-9.1%) and Greece (-7.8%) but better than Italy (-10%), Portugal (-10%) and Spain (-12.5%).

The government’s economic support package, of around 12.3% of GDP, should help absorb the shock and alleviate the impact on the labour market. The EU recovery programme will support Cyprus’s economic prospects in years to come: the country is expected to receive EUR 1.6bn from the Next Generation EU fund, on top of the EUR 1.45bn from the EU Multiannual Financial Framework, together totalling 14% of 2019 GDP.

Looking ahead, Scope is projecting that the Cypriot economy will recover and see real growth averaging 3.1% over 2021-24, underpinned by a strong rebound in 2021 of 5.8%, the country’s robust potential growth and a proven capacity to effectively absorb EU funds.

“Covid-19 will have a substantial near-term impact on Cyprus’s public finances but in contrast with other euro area countries, we expect Cyprus to reverse the deterioration in its public finances over the coming years,” said Alvise Lennkh, deputy head of the sovereign and public sector team of Scope Ratings and co-author of the report out today. “But this will depend critically on the strength of the economic recovery and whether banking sector vulnerabilities re-emerge and adversely impact public finances.”

Debt is likely to rise from 96% in 2019 to 110% in 2020, but Scope expects it to return gradually to pre-crisis levels by 2023-24, underpinned by the country’s robust growth potential and consolidation capacities.

So far, the banking sector has remained resilient, thanks to improvements in capital buffers, asset quality and liquidity, and the fact that the sector has significantly deleveraged since 2010. Cypriot banks’ total assets dropped from 800% of GDP in 2010 to 264% of GDP in 2019. Similarly, the NPL ratio reached 19.3% of risk-weighted assets (or 41% of GDP) at year-end 2019, its lowest level since 2010, while, at the same time, NPL provision coverage reached an all-time high of 55%. Nevertheless, NPLs remain at very high levels, well above those of Italy (6.7% of risk-weighted assets), Portugal (6.5%) and Spain (3.2%).

Financial institutions remain vulnerable to the re-emergence of NPLs due to high non-financial corporate debt and the financial fragility of Cypriot households. Household debt amounts to 90% of GDP while non-financial corporate debt is 167% of GDP. Both numbers are significantly higher than euro area averages of 64% and 147% respectively.

“Crystallisation of contingent liabilities in the banking sector through an increase of NPLs remains a key fiscal risk,” said Lennkh. “The emergence of a stressed scenario could destabilise the financial system, impede the country’s economic recovery and lead to more adverse fiscal outcomes over the medium term.”