By John Galt
July 27, 2011
Despite the proclamations of a miracle solution of paying off old debt by creating new debt for the PIIGS, it would appear that the entire European Union is heading for the ultimate destination that the U.S. is on:
Mega-Downgrades to Credit Hell
Cyprus becomes the latest member of the credit downgrade express and here is part of what Moody’s said in their statement this morning (Click on the title for the full statement):
Global Credit Research – 27 Jul 2011
London, 27 July 2011 — Moody’s Investors Service has today downgraded Cyprus’s government bond ratings to Baa1 from A2. The outlook is now negative. The rating agency has also downgraded Cyprus’s short-term rating to P-2 from P-1. Today’s rating action concludes the review for possible downgrade, which Moody’s initiated on 16 May 2011.
The key drivers for today’s rating action are:
1. Ongoing concerns about Cyprus’s fiscal position, which are amplified by the fiscal and economic consequences of the destruction of the Vasilikos power plant on 11 July 2011.
2. The increasingly fractious domestic political climate, which has increased implementation risks to the government’s new fiscal plans.
3. The material risk that at least some Cypriot banks will require state support over the medium term as a result of their exposure to Greece.
The negative outlook reflects Moody’s view that, in the current environment, the risks to the Baa1 rating are skewed to the downside.
Cyprus’s country ceilings for bonds and bank deposits are unaffected by Moody’s rating review and remain at Aaa (in line with the euro area’s rating).
RATIONALE FOR DOWNGRADE
The main driver of today’s two-notch rating action is Moody’s ongoing concern about Cyprus’s fiscal position, which has been amplified by the accidental destruction of the Vasilikos power plant on 11 July 2011 as a result of an explosion at a nearby naval base. Although the government has recently announced a range of structural measures intended to improve fiscal sustainability, the positive impact of those measures for the next few years will be reduced by the plant’s destruction. This incident has caused material disruption to the Cypriot medium-term economic and fiscal position. In view of the regular power outages caused by the destruction of this plant, Moody’s has reduced its forecasts for Cyprus’s economic growth to 0% in 2011 and 1% in 2012. Weaker economic activity also means that government revenues will be weaker than previously expected in 2011 and 2012.
The second driver of the downgrade is the increasingly fractious political climate in Cyprus in the wake of the plant’s destruction. This adverse development increases implementation risk to the government’s plans, many of which will require not just cross-party support, but also acceptance by the trade unions. Moody’s is concerned that reforms may be watered down or delayed in the process of winning broad approval for them.
The third driver of the downgrade is the material risk that the Cypriot government may need to extend capital support to at least some of its banks over the next few years given the substantial exposure of Cypriot banks to a sovereign default and macroeconomic stress in Greece. Cypriot banks remain heavily exposed to macroeconomic stress and Greek government bonds. Therefore, a period of prolonged macroeconomic stress would increase the likelihood that these contingent liabilities will crystallise on the Cypriot government’s balance sheet. The sovereign’s credit profile is affected by the banking sector’s large size relative to the size of the economy: bank assets total around 600% of GDP when excluding foreign banks’ subsidiaries/branches, and 860% of GDP if these are included. Overall, just under 40% of the total loans extended by the three largest domestic Cypriot banks are to customers based in Greece. Over the short term, however, Cypriot banks should remain well capitalised in spite of the private sector losses that will likely result from the distressed exchange in Greece that was announced last week. Indeed, the banks’ capital and liquidity buffers have been strengthened over the past year, thereby improving their shock absorption capacity.
Moody’s review of Cyprus’s sovereign rating was carried out in conjunction with its review of the ratings of the three rated Cypriot banks, the result of which is expected to be announced in a separate press release in the coming days.