CYPRUS may become the next trouble spot in the eurozone’s debt crisis, as credit rating agencies downgrade it because of exposure to Greece and rising yields suggest investor demand for its bonds is shrinking.
Cyprus does not face any near-term funding problem, and by many fiscal measures it is much healthier than Greece, Ireland and Portugal, which are receiving international bailouts.
But after a 0.8 percentage point jump in government bond yields during May, some analysts think the country might conceivably have to seek a bailout in the long term.
“There is an increasing risk that Cyprus might join the GIP (Greece, Ireland and Portugal). It is not necessary, but many indications point towards Cyprus getting closer to asking for external help,” said David Schnautz, an interest rate strategist at Commerzbank in London.
A Commerzbank research report last week recommended that investors refrain from buying Cypriot government bonds.
“My view is that many investors look at Cyprus as being very, very close to Greece, and if they don’t touch Greece anymore they won’t touch Cyprus either,” Schnautz said.
A euro-denominated Cypriot 10-year government bond issued to international investors in February 2010 was bid at 7.01 per cent on Thursday, up from around 6.20 per cent in mid-May and 4.20 per cent in the middle of last year.
During the crises in Greece, Ireland and Portugal, investors viewed the 7 per cent level as a danger signal for 10-year bond yields, believing governments might be unable to afford to fund themselves over the long term at such an expensive level.
Cyprus accounts for only about 0.2 per cent of the 17-nation eurozone’s economy and has gross financing needs of roughly €2 billion this year, which is tiny compared to the €110 billion size of Greece’s three-year bailout programme.
So the European Union could easily afford any rescue of Cyprus. However, a fourth bailout in the eurozone could unsettle markets by underlining the way in which the debt crisis can spread as problems in one country affect other states.
With its banks sitting on an estimated €5 billion in Greek sovereign debt and its economy heavily exposed to Greece through trade, Cyprus has been downgraded by all three major credit rating agencies over the past several months as the Greek crisis has worsened.
Cypriot banks have taken steps to boost their capital in the past year and Fitch said they were “relatively well placed” to withstand even a 50 per cent cut in the principal of Greek bonds.
It estimated the cost of recapitalising the banks to a Tier 1 ratio of 10 per cent under that scenario would be €2 billion or 11 per cent of gross domestic product.
Cyprus would actually be in better shape than many other eurozone countries to shoulder such a burden. Its debt to GDP ratio is projected by the EU at 62.3 per cent this year, lower than the weighted average for the zone; Greece’s ratio is 157.7 per cent and Ireland’s, 112.0 per cent.
Its projected budget deficit this year is 5.1 per cent, well below Greece’s 9.5 per cent and Ireland’s 10.5 per cent.
But another issue is also worrying investors: the government’s delay in cutting back high expenditure on a bloated civil service and addressing pension reform. The public payroll accounts for 30 per cent of annual budget spending, and if steps are not taken, it could hit 50 per cent in coming years, central bank governor Athanasios Orphanides told parliament last year.
“It’s easy to say the markets and rating agencies are jittery right now, but something must be done to address concerns,” said Michalis Florentiades, head of economic research at Hellenic Bank.
The Finance Ministry says the significance of the rise in secondary market bond yields should not be overestimated. A report by the Public Debt Management Office in March described it as an illiquid market with no primary dealers, where a lack of volume data hindered an objective assessment.
“Traditionally Cyprus has been able to shun international markets in favour of domestic,” said economist Fiona Mullen. “The local banks were always very liquid; they have only gone to international markets to get a benchmark in the past.”
Between 2004 and 2007, when Cyprus was running similar deficits to today, it borrowed more than €7 billion from local banks in short-term Treasury bills. It did not tap the international market between 2004 and 2009.
But staying out of the international market for too long would be risky for Cyprus; it could lose touch with foreign investors, making it more difficult to raise money from them if banking or economic problems required the government to raise more money than expected.
