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The downgrades of the long-term foreign and local currency IDRs reflect the resolution of the RWN assigned to the ratings on 26 March, 2013. At that time, Fitch stated that it would resolve the RWN once details of the EU/IMF programme had been agreed and also made public, taking into consideration the official parameters and the credibility of the assumptions, including those on the economic and fiscal outlook and terms of financing and fiscal sources and uses.
The downgrade of the foreign currency IDR to 'B-' reflects the elevated uncertainty around the outlook for the Cypriot economy due to the high implementation risks on the agreed programme and the restructuring of the banking industry. Fitch acknowledges that the programme improves the immediate position of the sovereign from both a liquidity and solvency perspective (the May ESM loan disbursement of €2 billion will be used to pay the €1.4 billion EMTN due in June). However, Cyprus has no flexibility to deal with domestic or external shocks and there is a high risk of the programme going off track, with financing buffers potentially insufficient to absorb material fiscal and economic slippage. A premature lifting of capital controls that triggers material capital flight could have large negative economic consequences.
Public debt is likely to peak higher than the 126 per cent of GDP by 2015 assumed under the programme, reflecting Fitch's assumption of a deeper recession in the later years of the programme and a slower recovery than that assumed, with little visibility at this stage of the potential for Cyprus to transform its economy successfully away from sectors associated with the shrinking financial sector.
While the government has approved and agreed consolidation measures of just over 7 per cent of GDP for the period 2013 to 2018, a further 4.7 per cent of additional yet unidentified measures will be needed under the programme assumptions to hit the 4 per cent of GDP target for the primary fiscal balance by 2018 which is required to reduce the debt load to the Troika's target of close to around 100 per cent of GDP by 2020. The deteriorating economic situation will make it increasingly difficult to identify new measures, which are expected to be focused on the expenditure side. Revenue generation from some of the announced measures is also uncertain, including privatisation proceeds.
Fitch's two notch downgrade of the local currency IDR to 'CCC' and the consequent one notch differential with the foreign currency IDR at 'B-' reflects the agency's assessment of the greater vulnerability of bonds issued under domestic law relative to foreign law bonds. The financing assumptions underpinning the EU-IMF programme reveal a preferential treatment of foreign law sovereign bonds. The May IMF report on the programme modalities makes a distinction between foreign law bonds and domestic law bonds, opening up the possibility of "a voluntary sovereign bond exchange covering bonds maturing in 2013-15" for the latter in the event of the programme going off track.
In the near term, the Cypriot government intends to roll over the €0.7 billion of domestic law bonds due in July 2013, but the agency notes that there are also redemptions due early in 2014 and 2015. Fitch acknowledges that it remains unclear if a domestic debt swap will be implemented and whether the terms of any such operation would be considered a distressed debt exchange and hence an event of default from a rating perspective. Nonetheless, in Fitch's opinion, the authorities may seek relief on domestic debt in the event that financing gaps emerge because of difficulties in meeting fiscal and other programme targets. Fitch's 'CCC' rating encapsulates substantial credit risk and acknowledges that a restructuring is a real possibility. In contrast, redemption of foreign law sovereign debt is currently fully covered by the EU-IMF programme. The one notch higher rating of foreign law sovereign bonds (reflected in the foreign currency IDR) reflects Fitch's opinion that the risk of restructuring these bonds is somewhat lower than that of domestic law bonds.