Atradius Country ReportCyprus – May 2013

Nicosia

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Cyprus: Atradius STAR Political Risk Rating*:

7 (Impaired) – Stable

* The STAR rating runs on a scale from 1 to 10, where 1 represents the lowest risk and 10 the highest risk.

The 10 rating steps are aggregated into five broad categories to facilitate their interpretation in terms of credit quality. Starting from the most benign part of the quality spectrum, these categories range from ‘High Quality’, ‘Good’, ‘Adequate’, ‘Impaired’ to ‘Prohibitive Conditions’, with a separate grade reserved for ‘Off Cover.’ In addition to the 10-point scale, there are rating modifiers associated with each scale step: ‘Positive’, ‘Stable’, and ‘Negative’. These rating modifiers allow further granularity and differentiate more finely between countries in terms of risk.

For further information about the Atradius STAR rating, please click here

Overview

General information Most important sectors (% of GDP, 2012)Capital: Nicosia Services: 81 %Government type: Parliamentary democracy Industry: 17 %Currency: Euro (EUR) Agriculture: 2 %Population: 0.8 million

Main import sources (2011, % of total) Main export markets (2011, % of total)Greece: 22 % Greece: 32 %Israel: 10 % UK: 12 %UK: 9 % Germany 6 %Italy: 8 % Italy: 4 %Germany: 8 % Lebanon: 3 %

Current sovereign risk ratings

April 2013

S&P CCC Stable

Fitch B Negative

Moody’s Caa3 Negative

The bailout programme

Framework of the Cyprus bailout

Cyprus, one of the smallest Eurozone countries, has recently experienced a total standstill in its local economy. Cyprus is highly indebted, with a large exposure to Greece. As a result, the Cypriot banking system, which has until recently contributed 60 % of GDP, suffered massive losses as Greece restructured its debt in 2012: Cypriot banks hold Greek government bonds worth EUR 5.5 billion and granted loans worth EUR 23 billion to Greek clients. Cypri-ot banks had already been downgraded by rating agencies in 2011 because of their close connection to Greece: reports indicated that one third of the assets of Cyprus’ bank related to Greece. The ‘haircut’ imposed on Greek debts had an impact on Cyprus’ financial sector of around EUR 10 billion.

A bailout agreement made between the Cypriot government and the so-called Troika (IMF, the ECB, and the Eu-ropean Commission) on 24 March 2013 helped avoid a disorderly sovereign default by Cyprus. The initial amount of the rescue package was EUR 17.5 billion, of which the Troika agreed to contribute EUR 10 billion, while deposit holders would have to make up the remaining sum. On the back of the Troika rescue package, Russia has agreed to extend the maturity of its EUR 2.5 billion loan from 2016 to 2021.

This agreement came after the Cypriot parliament rejected an initial deal under which Cypriot deposit holders would have lost a share of their savings (among other measures, 6.75 % of bank deposits of less than EUR 100,000). Cyprus’ government even considered a Eurozone departure but this was quickly dismissed. The final agreement targets only deposits of more than EUR 100,000 and only accounts in the major troubled banks: Laiki and Bank of Cyprus (BoC).

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Key Indicators

**

2009 2010 2011 2012 2013*

Real GDP growth (y-on-y, % change) -1.9 1.3 0.5 -2.4 -8.2

Consumer price inflation (y-on-y, % change) 0.3 2.4 3.3 2.4 1.2

Real private consumption (y-on-y, % change) -7.5 1.5 0.5 -3.0 -4.1

Retail sales (y-on-y, % change) -5.8 0.6 -0.1 -5.0 -6.6

Industrial production (y-on-y, % change) -7.9 -0.7 -7.5 -9.7 -4.7

Unemployment rate (%) 5.4 6.3 7.9 11.9 15.9

Real fixed investments (y-on-y, % change) -9.7 -4.9 -13.1 -23.0 -24.1

Export of goods and non-factor services -11.8 3.8 4.4 2.4 -0.5(y-on-y, % change)

Real net exports (EUR billion) -0.3 -0.7 -0.2 1.3 1.3

Fiscal balance (% of GDP) -6.0 -5.3 -6.2 -5.5 -4.7

* forecast Source: IHS Global Insight

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However, the initial amount of the rescue package - EUR 17.5 billion - was raised to EUR 23 billion during the EU and Eurozone Finance Ministers’ meeting in Dublin on 12 and 13 April. While the EUR 10 billion amount provided by the Troika is unchanged, the ‘bail-in’ contributions by shareholders, bondholders and deposit holders in Laiki Bank and the BoC have risen to EUR 13 billion.

Although these discussions led to uncertainty among deposit holders across the Eurozone, so far financial markets have reacted calmly.

Details of the bank restructuring programme

The Troika rescue package consists of a bank restructuring and a supporting macroeconomic adjustment pro-gramme. The former affects the two main banks, Laiki Bank and BoC, while no further actions affecting other banks are envisaged.

Laiki bank (with an asset portfolio amounting to EUR 30 billion, or 170 % of GDP) will identify and separate out insured deposits (up to EUR 100,000), and ECB emergency funding (totalling EUR 9.2 billion) and corresponding assets. This part of Laiki Bank will be transferred to the BoC (whose assets are worth EUR 36 billion). The remaining part of Laiki Bank will be frozen and gradually wound down. The BoC will subsequently be recapitalised, bring-ing the Core Tier 1 capital ratio to 9 %. Uninsured deposit holders and bondholders in the two banks may lose an amount of EUR 7.5 billion (possibly as much as 60 % of their claims). Indeed, their loss may be higher: EUR 13 billion if the full EUR 23 billion rescue package proves necessary.

To avoid contagion spreading to Greece, the Greek operations of Laiki Bank and BoC, together with Hellenic Bank, will be transferred to Piraeus Bank, which in turn will be recapitalised by EUR 1.5 billion from the Greek bank reca-pitalisation fund (which is part of the Greek rescue operation). This will also reduce the size of the Cypriot banking sector by an equivalent of 100 % of GDP.

After the recapitalisation is complete, the restructured BoC will have an asset base of EUR 23-25 billion, compa-red to the EUR 66 billion previously held by BoC and Laiki Bank combined: a reduction in size by 244 % of GDP. Together with the sale of the Greek operations, this will remove around 350 % of the initial 800 % of GDP. But the banking sector still needs to be reduced further: the Troika is aiming for 400 % of GDP by 2018.

Macroeconomic adjustments

As mentioned, beside the bank restructuring scheme, a macroeconomic adjustment programme is linked to the EUR 10 billion funding from the Troika, which aims to bring government debt below 100 % of GDP by 2020. The aim of the programme is to help the economy adjust after the bank restructuring, given its severe impact on Cyprus´ economic structure and growth potential.

The programme entails an additional adjustment of 2 % of GDP on top of the three-year fiscal adjustment of 4.5 % of GDP already underway. This will be achieved by raising the corporate income tax to 12.5 % (from 10 %) and in-creasing the tax rate on interest earned to 30 % (from 15 %). Additionally, these measures are to be taken over the medium term in order to achieve a 4 % primary budget surplus.

The Cypriot government will have a refinancing need of EUR 7.2 billion over the period 2013 to 2015. This consists of medium- and long-term debt repayments, the refinancing of bond issues to recapitalise Laiki Bank, and short term debt repayment. The remainder (EUR 2.8 billion) will therefore be available to finance deficits.

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Assessment of the economic impact

A severe economic contraction in 2013 and 2014

Before the bailout agreement, the GDP forecast was for a contraction of 3.5 % in 2013 and 2.3 % in 2014. However, these expectations are no longer tenable. According to IHS Global Insight, the economy will shrink 8.2 % year-on-year in 2013, while the Institute of International Finance (IIF) expects a contraction of 9.5 % this year, followed by 9.2 % in 2014 and 1.7% in 2015. The ability of the banking sector to provide companies with credit facilities will be extremely limited. This will have a tremendous negative impact on the whole economy: in particular for locally operating businesses and private consumers.

*forecast

Source: IHS Global Insight

To assess the full impact of the events and put the large negative GDP figures into perspective it is worthwhile considering the various ways in which the banking crisis will hit the economy:

Massive job losses

Firstly, 2,300 employees will immediately be made redundant with the closure of the Laiki Bank. The process of reducing the size of the banking sector will also impact other professions and sector segments such as accounting and business services (such as IT). At the same time, the fiscal adjustment plan calls for a downsizing of the public sector (which currently accounts for 25 % of GDP) leading to further job losses. As unemployment is likely to rise to 20 % in the coming 12 months, its effect will be felt immediately in retail sales, which are expected to decrease 6.6 % year-on-year in 2013 (see chart on page 2).

Adverse effects on wealth

The Troika estimates that uninsured deposits and bond holdings amount to EUR 4 billion - equivalent to 22 % of GDP - and these will be partly lost. The Cypriot economy will therefore experience spending and investment constraints as households and firms will simply lose their wealth, although a large proportion of these deposits is believed to be held by non-residents.

(% change on previous year)

GDP growth

4

2

0

-2

-4

-6

-8

-10

2009 2010 2011 2012 2013*

1.3

-2.4

0.5

-8.2

-1.9

*forecast

Source: IHS Global Insight

Credit constraints

As the downsizing of the banking sector continues, banks will be very reluctant to lend, with a consequent severe impact on the real estate market. House prices will fall, adding to the reduction in wealth felt through lost deposits. Average real estate prices had already decreased by 9 %-10 % in 2012, while building permits and real estate sales decreased sharply. This has massive repercussions for the construction sector.

Disruption to the payment system

This will result from the temporary closure of the banking system, the limit on cash withdrawals (currently capped at EUR 300 per day), and the imposition of capital controls. The latter are needed (and temporarily compliant with EU law) to prevent a run on the banks and a total collapse of the banking system.

Deteriorating confidence

In view of the problems described, uncertainty about how and when the Cypriot economy will recover from the shock of the bank restructuring remains high. This will hurt confidence and add to the negative effects in terms of reduced spending and delayed investments.

*forecast

Source: IHS Global Insight

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(% change on previous year)

Real private consumption

4

2

0

-2

-4

-6

-8

-10

2009 2010 2011 2012 2013*

1.5

-3.0

0.5

-4.1

-7.5

(% change on previous year)

Real fixed investment

5

0

-5

-10

-15

-20

-25

-30

-4.9

-23.0

-13.1

-24.1

2009 2010 2011 2012 2013*

-9.7

Rising government debt

The expected massive economic contraction in 2013 and 2014 will put severe pressure on government revenue. As a result of higher unemployment, social security contributions will be lower and outlays higher. Moreover, interest payments will rise as higher debt accumulates. As a consequence, the government deficit will increase further: from 4.7 % of GDP in 2013 to 5.7 % in 2014 and 7.4 % in 2015. Government debt as a percentage of GDP will increase from 99 % in 2013 to nearly 120 % in 2016.

Source: IHS Global Insight

Outlook Despite the bailout package, many risks remain, with considerable uncertainty about the impact of the banking sector restructuring: the cumulative GDP contraction of about 20 % expected for 2013-2015 may well turn out to be higher. Greece’s experience shows how far-reaching the economic adjustment can be: the level of Greek GDP is almost 25 % lower than in 2008. Troubles are compounded by the fact that, with the downsizing of the banking sector, the whole Cypriot ‘business model’ has to be fundamentally changed.

Recently discovered off-shore gas deposits could help in this respect, but the size - and hence future value - of these discoveries are uncertain, as are the cost of the exploitation development and infrastructure. Apart from that, political conflicts may emerge with the Turkish part in the North and Turkey itself due to overlapping claims. There-fore, the benefits of any offshore gas extraction are unlikely to materialise before 2020.

As a result, the macroeconomic adjustment programme is likely to be fine-tuned and revised along the way, as will be the associated EUR 10 billion: a view supported by developments in other Troika programme countries, such as Greece, Portugal and Ireland.

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(Fiscal balance as percentage of GDP)

Budget balance: Cyprus

Disruption to the payment system This will result from the temporary closure of the banking system, the limit on cash withdrawals (currently capped at EUR 300 per day), and the imposition of capital controls. The latter are needed (and temporarily compliant with EU law) to prevent a run on the banks and a total collapse of the banking system. Deteriorating confidence In view of the problems described, uncertainty about how and when the Cypriot economy will recover from the shock of the bank restructuring remains high. This will hurt confidence and add to the negative effects in terms of reduced spending and delayed investments. Bitte Graphik einfügen Real fixed investment (% change on previous year) Source: IHS Global Insight Rising government debt The expected massive economic contraction in 2013 and 2014 will put severe pressure on government revenue. As a result of higher unemployment, social security contributions will be lower and outlays higher. Moreover, interest payments will rise as higher debt accumulates. As a consequence, the government deficit will increase further: from 4.7% of GDP in 2013 to 5.7% in 2014 and 7.4% in 2015. Government debt as a percentage of GDP will increase from 99% in 2013 to nearly 120% in 2011.

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