Fitch ratings cut Cyprus's sovereign rating to A- from AA- today, saying it was concerned at the high level of exposure its banks had to Greek debt and the impact that it could have on the island's finances.
The outlook was negative, the agency said.
Fitch said that it believed Cypriot banks were "relatively well placed" to absorb the impact of an assumed 50 per cent haircut on Greek bonds, but that worse-case scenarios could have a knock-on effect on Cyprus's own debt profile.
"The downgrade reflects the severity of the crisis in neighbouring Greece and the risk this poses for the Cypriot banking system and consequently the public Finances of Cyprus," said Chris Pryce, Director in Fitch's Sovereign Group.
The move came as the European Union is racing to draft a second bailout package for Greece to release vital loans next month and avert the risk of the euro zone country defaulting on its debt.
Recapitalising banks in Cyprus with a 50 per cent haircut could cost €2 billion, only part of which may have to be assumed by the state, the agency said.
Exposure to Greece was a significant source of vulnerability which had intensified with sucessive downgrades of the Greek sovreign since January 2011, Fitch said.
Cyprus's ratings have been on a downward spiral for the past six months. It has reflected growing concern of ratings agencies at the impact of a potential Greek debt restructure on Cypriot banks, and the ability of the domestic government to come to their aid if required.
About one third of assets of banks based in Cyprus, including that of Greek subsidiaries on the island, was booked as Greek exposure, Fitch said.
"Fitch believes that these banks are relatively well placed to absorb the impact of a sovereign debt crisis in Greece that entailed an assumed 50 per cent haircut to face value of Greek government bonds," it said.
In that scenario the cost of recapitalising the banks to a tier 1 ratio of 10 percent would be €2 billion, or 11 per cent of Cyprus's GDP.
But in a more severe stress test where a Greek default were associated with significant deterioration in asset quality the cost could rise to 25 per cent of GDP - placing strain on Cyprus's debt profile.
The island itself, one of the smallest in the eurozone, is struggling to keep a lid on its public deficit, a high public payroll and anaemic growth which has sapped tax revenues.
Moody's placed Cyprus on notice on May 16th that its A2 rating was on review for a possible downgrade while Standard and Poor's have cut Cyprus twice since last November.
Reuters
