Moody's Investors Service cut Cyprus's sovereign ratings to junk on Tuesday, saying there was a heightened risk the government, shut out of debt markets, would have to support its banks that have been battered by exposure to Greece.
Moody's cut the island-state one notch to Ba1 from Baa3. The outlook was negative, it said.
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It is the second ratings agency to cut Cyprus to junk, after Standard and Poor's, which has Cyprus at BB+. Fitch rates Cyprus BBB-, one notch above junk.
Among other euro zone countries, Portugal is rated junk by all three rating agencies, Ireland has one junk rating from Moody's, and Greece is either rated junk or in default by all three.
Moody's said there was an increased risk the Cypriot government, itself shut out of financial markets for funding, would have to prop up banks. It said the level of recapitalisation required could exceed 20 percent of Cyprus's GDP.
In a statement, Cyprus's finance ministry said it believed the downgrade was unjustified because conditions had not materially changed since Moody's last cut its ratings in November.
It said that it would continue to work to meet fiscal targets and cooperate with the central bank to meet challenges in the banking sector.
Cyprus, the euro zone's third-smallest economy with a gross domestic product of about 17 billion euros, has been hammered by ratings agencies for fiscal slippage and exposure of its banks to Greece's sovereign debt and its economy.
Not a frequent borrower on international markets, its borrowing costs are nonetheless prohibitive. It turned to close ally Russia for a 2.5 billion euro bilateral loan which authorities say will cover its needs this year.
The yield on a 10-year bond was quoted at 13.04 percent on Tuesday, according to Reuters data.
Moody's downgrade focused primarily on Cyprus's risks from Greece, while acknowledging that the island had undertaken fiscal consolidation and a greater number of structural changes than anticipated.
Cyprus's two largest banks, Bank of Cyprus and Marfin Popular posted record losses after taking a writedown on Greek sovereign holdings. Marfin Popular, which held 3.0 billion in Greek government bonds before the writedown, needs to boost its capital by 1.35 billion euros by the end of June.
The bank says it plans to offer equity either to existing shareholders or new ones. It says it is talking to investors, but has not provided further details.
Moody's estimated that under the banks' participation in Greece's private sector debt-swap scheme, and factoring in a deterioration in asset quality in Cyprus and Greece, the banks would need a capital increase equivalent to more than 20 percent of GDP.
Although some of this capital is included in present bank recapitalisation plans, Moody's said there was a "very material risk" that the private sector would not be able to provide all the capital needed.
"Overall, the fragile market confidence in Cyprus, which has already led to a loss of access to international debt markets, is likely to continue, with a high potential for further shocks to funding conditions for the sovereign and the domestic banks," Moody's said.
Its decision to assign a negative outlook was a reflection of "very significant risks" that continue to emanate from the Greek sovereign crisis, and which will continue to challenge Cyprus over the next 18 to 24 months, it said.
It said its downgrade was limited to one notch, acknowledging a government fiscal consolidation programme and the discovery of substantial gas reserves off the island's shores.
Cyprus announced a discovery of between 5 and 8 trillion cubic feet of gas in an offshore field in December. It has now declared a licensing round for another 12 blocks.
Although authorities are likely to realise some one-off gains from the sale of licences to tap reserves, it will probably take nearly a decade for the island to realise the most significant and sustained benefits, Moody's said.