International ratings agency Moody's on Friday cut Cyprus' credit grade by two notches to Baa3, or just above junk status, and warned of further downgrades because its banks will likely need state support next year over their heavy exposure to Greek debt.
Moody's said in a statement that Cypriot banks' losses have more than doubled under last month's new European debt deal for Greece that would see banks write off 50 percent of the money the country owes them.
Those higher losses make it more likely that the government would need to step in and provide a financial backstop of around (EURO)1 billion ($1.38 billion), raising, in turn, the government debt-to-gross domestic product ratio by 5-10 percentage points.
Cyprus' top three banks hold an estimated (EURO)5 billion ($6.89 billion) in Greek government bonds. Cypriot Finance Minister Kikis Kazamias said the island's debt currently stands at around 65.5 percent of GDP.
Moody's also cited the Cypriot government's inability to borrow from international markets which raises the possibility that authorities will need to seek emergency funding from official sources like Europe's bailout fund, or European Financial Stability Facility.
Rising interest rates on Cypriot bonds have made it increasingly difficult for the government to borrow from the secondary markets in order to finance the island's debt and cover costs.
Cyprus, a eurozone member since 2008 with a GDP of around (EURO)18.74 billion ($25.81 billion), has turned to Russia for a 4 1/2-year, (EURO)2.5 billion ($3.44 billion) loan agreement at a 4.5 percent annual interest rate which is much lower than markets are currently offering.
"As in the case for a number of countries in the euro area, the difficulties that Cyprus has faces over the past year are likely to have a long-lasting impact on investors' perceptions of the riskiness of government debt, and therefore the sovereign's medium-term funding costs," Moody's said.
The agency said, however, that the Russian loan should satisfy most of Cyprus' funding needs for next year and meet any immediate liquidity pressures.
Moody's also pointed to the island's difficulties in swiftly approving and implementing budgetary and structural reforms needed to fix the government's rising debt and to shore up the long-term sustainability of its public finances.
It noted that the government has been unable to respond "decisively and credibly to shocks" such as the wrecking in July of the island's main power station following the detonation of seized Iranian munitions that were stored at a nearby naval base.
"In the months since the plant's destruction, the Cypriot government has faced a number of delays in passing fiscal consolidation measures, and structural reform measures appear to be playing a smaller role than previously envisaged," Moody's said.
The agency also noted concerns that squabbling among political parties, as well as trade unions, could hinder the government from pushing through reforms.
Cyprus' 2012 draft budget aims at cutting the deficit from 6.5 to 2.8 percent and includes a (EURO)840 million ($1.15 billion) package of spending cuts and tax increases. But opposition parties say it doesn't go far enough to roll back a bloated civil service that takes up around a third of all government spending.
This is the latest in a string of credit grade downgrades for Cyprus by all three major ratings agencies. Last week, Standard & Poors cut Cyprus' credit grade by one notch to BBB, or two notches above junk status, over similar concerns. Fitch downgraded the island to BBB in August.