Moody's Investors Service placed the island’s three leading banks on review for a possible downgrade and warned Cyprus it could cut its Aa3 sovereign credit rating on Thursday, citing the island's deteriorating fiscal standing and banks' high exposure to Greece.
Moody’s said the rating may be cut by more than one notch but that it is likely to remain an investment-grade credit.
Later Thursday, the rating agency also placed Cyprus's three dominant banks, Bank of Cyprus, Marfin Popular and Hellenic on review for a possible downgrade.
Concerns about a worsening in Cyprus's fiscal metrics, deep-rooted structural problems and exposure to Greece among local banks prompted the review, Moody's said.
"It's important to note that all three were factors behind the decision, not just the banking sector," Sarah Carlson, Moody's lead sovereign analyst for Cyprus, told Reuters.
Standard & Poor's cut Cyprus's sovereign rating in November, by one notch to A with a negative outlook. Fitch has a AA- rating on Cyprus, affirmed in June 2010, and a stable outlook.
These ratings, still well within the investment grade band, have helped Cyprus to hold down its borrowing costs. The island is one of the euro zone's smallest economies.
Responding to the Moody's warning, Cyprus's finance ministry said in a statement that it had already covered its medium-term financing requirements and need not borrow during "exceptionally difficult" current market conditions.
Finance Minister Charilaos Stavrakis said on December 22 that Cyprus is likely to tap international markets late in 2011 to cover an estimated 1.3 bln euros in maturing debt.
The island's debt to gross domestic product (GDP) ratio is forecast at 61.6% this year, slightly higher from 61% in 2010.
BANKING SCRUTINY
Carlson said Moody's review would also focus on the Cypriot banking sector's exposure to Greece.
"Capital and liquidity levels are not a source of major concern, but the banking sector's size compared to the economy is large and its exposure to macroeconomic stress in Greece is substantial," Carlson said.
Bank of Cyprus and Marfin Popular Bank have a significant presence in Greece, which is projected to stay in recession for a third straight year in 2011 as it struggles to dig its way out of a debt crisis.
The Cypriot finance ministry said it was confident the banking sector was robust and able to withstand any shocks.
Cyprus is trying to cut its budget deficit to 3.8% of GDP this year from an expected 5.5% in 2010.
Value-added tax increases on food came into effect this year, and the government plans to tax bank deposits in excess of 100,000 euros, but other issues, such as pension reform, have been put on hold for debate with the island's powerful unions.
Carlson cited rigidities in Cyprus's budget, saying that maintaining deficit reductions over a number of years could be very difficult. It is also assessing the country's ability to overcome challenges to its competitiveness.
"One of the things that has become very apparent is that while competitiveness issues may look many years away, they can quickly become problems of today," Carlson said.
