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

KEY RATING DRIVERS

The upgrade of Cyprus's IDRs reflects the following key rating drivers and their relative weights:

HIGH

Cyprus has established a track record of fiscal consolidation and over-performance on its fiscal targets. In 2014, Cyprus achieved an almost balanced general government position (excluding a one-off EUR1.5bn capital injection to the cooperative banking sector) compared with a deficit of 8.5% of GDP originally projected by Fitch in June 2013, when the agency downgraded Cyprus's Long-term foreign currency IDR to 'B-'. The positive momentum has carried over to 2015 and the budget has remained in slight surplus as of end-July 2015, with Fitch now projecting a deficit of 1% of GDP for 2015 and surpluses of 0.2% and 1% for 2016 and 2017, respectively.

General government gross debt (GGGD) is now expected by Fitch to peak at less than 108% of GDP this year, before falling to around 100% in 2017. This compares with a peak of over 130% projected by Fitch in June 2013. At more than double the 'B' median of 43% for 2015, the GGGD ratio is still high and reduces Cyprus's fiscal scope to absorb domestic or external shocks. The stock of government guarantees is also sizeable at 17% of GDP, although over half is already included in the reported GGGD stock.

Cyprus is back on track in its IMF-EU programme following delays in the fifth and sixth reviews that were pending the implementation of the foreclosure law, finally passed in May 2015. The seventh review took place in July and enabled the disbursement of EUR625m in funding.

The foreclosure law, along with a new insolvency framework, lies at the heart of the banking sector efforts to reduce its exceptionally high stock of non-performing exposures (NPEs). A significant programme hurdle was overcome in removing all restrictions on capital flows in April, ending two years of controls. Deposits have been broadly stable since then, although non-resident deposits (30% of total) declined temporarily in the run-up to the Greek crisis this summer. While direct financial links between Greek-owned subsidiary banks and Greece have been reduced significantly, the sector remains vulnerable to Greece mainly via investor confidence.

MEDIUM

Growth during 2015 turned positive for the first time since Q111, leading to an upward revision in Fitch's forecast for 2015 to growth of 1.5% from a decline of 0.8%. Fitch estimates a smaller cumulative loss in output since 2013 at 7.5%, compared with 14% projected by Fitch in June 2013. Growth has been supported by domestic demand, which in turn is buoyed by lower oil prices and an improvement in sentiment. Tourist arrivals were up 14% yoy in September, despite a decline in arrivals from Russia. The labour market is improving but remains weak; unemployment was still above 15% in August compared with less than 4% in 2008.

Cyprus's 'B+' IDRs also reflect the following key rating drivers:

There are still significant risks to creditworthiness posed by Cyprus's continued deep economic and financial adjustment.

The environment for banks remains challenging, in particular with regard to exceptionally weak asset quality. The stock of consolidated sector NPEs was 47.4% of gross loans in August, the highest of all Fitch-rated sovereigns. Unreserved problem loans for the sector (ie gross NPEs minus system-wide provisions) stood at EUR18.8bn, or 107% of GDP for the same period.

Implementation risks around banking reforms remain high as the process is dependent on the political will to confront debtors, which could wane in the run-up to parliamentary elections in May 2016. Though evidence is emerging of a pickup in restructuring and NPE stock stabilisation, along with improved capitalisation and liquidity, any corresponding decline in NPEs will only emerge gradually. With assets of almost 5x GDP, the banking sector weighs on the overall credit profile of Cyprus by rendering it more vulnerable to external shocks. Uncertainty in Greece, a global economic downturn, or deterioration in the Russian economy could undermine Cyprus's adjustment.

At 108% of GDP as of 1Q15, Cyprus's net external debt (NXD) reflects a highly indebted private sector (external private sector debt was over 350% of GDP in 1Q15). The NXD figure was revised up by over 60% of GDP following a shift of external statistics compilation to the BPM6 framework in June 2014. Ship owners are now counted as Cypriot economic units irrespective of the location of their activities, which increases the NXD position owing to the capital-intensive nature of the shipping industry (debt-financed real assets).

The current account deficit has narrowed to 5% of GDP in 2014 from 14% in 2008, and will continue to shrink according to Fitch projections, albeit gradually to around 3.5% by 2017. Cyprus's weak external position implies that further economic rebalancing may be in prospect over the medium term.

Debt management operations aimed at improving the debt profile should help ease market access during the post-programme period. Market conditions allowing, Cyprus plans to issue another eurobond before end-2015 to further lengthen maturities and to increase its cash buffer. A EUR860bn bond redemption due in November is already covered by the country's sizeable cash position (close to EUR2bn or 11% of GDP), while maturities are moderate until 2019, with just over EUR500m of medium- and long-term debt falling due in 2016, EUR284m in 2017, and EUR20m in 2018.

RATING SENSITIVITIES

Future developments that may, individually or collectively, lead to an upgrade include:
-Further signs of a stabilisation in the banking sector, including a pickup in loan restructurings
- A sustained track record of market access at affordable rates
- Continued adherence to fiscal adjustment targets, leading to a decline in the government debt- to-GDP ratio
- Further track record of economic recovery and narrowing of the current account deficit.

Future developments that may, individually or collectively, lead to a negative rating action:
- Re-intensification of the banking crisis in Cyprus
- A weakening in the pace of fiscal consolidation, resulting in a less favourable trajectory in the debt-to-GDP ratio
- A return to recession or deflation, which would have adverse consequences for public debt dynamics.
- 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% of GDP, trend real GDP growth averaging 1.7%, an average effective interest rate of 3.3% and GDP deflator inflation of 1.5%. On the basis of these assumptions, the debt-to-GDP ratio would peak at almost 108% in 2015, and edge down to 87% by 2024.

Gross debt-reducing operations in the EU-IMF programme such as privatisation (EUR1.4bn by 2018) and a mooted asset swap for a government loan held by the Central Bank of Cyprus (up to EUR1bn) are not considered in Fitch's assessment of Cyprus's debt dynamics. Our projections also do not include the impact on growth of future gas reserves off the southern shores of Cyprus, the benefits from which are several years into 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. Russians accounts for around 20% of the total tourism market share, and 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's base case is that Greece will remain a member of the eurozone, though it recognises that 'Grexit' is a material risk. Cyprus is among the most vulnerable to a 'Grexit' shock. However, its ties to Greece have been reduced significantly. Cypriot banks no longer hold any Greek government bonds and are no longer exposed to the Greek private sector, owing to the fire-sale of the Greek operations of Cypriot banks in March 2013. The subsidiaries of the big four Greek banks in Cyprus have also been ring-fenced. Fitch considers that Cyprus remains vulnerable to Greece mainly via investor confidence.