International ratings agency Moody's on Tuesday downgraded Cyprus' three most Greece-exposed commercial banks because of what it considers to be the small island nation's diminished ability to back them up.
Moody's downgraded Marfin Popular Bank by three notches to Ba2 and cut Bank of Cyprus and Hellenic Bank by one notch to Ba1. The agency added that the three banks, which are the island's largest lenders, could be downgraded again.
The downgrade illustrates how the Cypriot economy, which is projected to grow by a mere 0.2 percent in 2012, is caught in a vicious spiral. Last week, Moody's cut Cyprus' sovereign credit rating by two notches, to Baa3, over what it said was the increased likelihood that its large financial system _ equivalent to six times the island's GDP _ may need government support next year.
Another cut and Cyprus' sovereign rating will be considered junk, raising fears that it may join the ranks of eurozone countries needing a financial bailout.
The other two major credit rating agencies, Standard & Poors and Fitch, grade Cyprus at BBB, or two notches above junk.
Cyprus is trying to push through parliament a raft of spending cuts and tax increases worth euro840 million ($1.2 billion) that aim to shrink the deficit _ now around 6.5 percent of gross domestic product _ to under 3 percent of GDP next year.
Opposition parties are clamoring that those measures aren't enough to rein in a bloated public sector which takes up around a third of all government spending.
Finance Minister Kikis Kazamias told state radio on Tuesday that more austerity measures are in the offing in light of the worsening economic outlook throughout the eurozone, but he did not provide details.
To make matters worse, high interest rates on Cypriot sovereign bonds have made it increasingly costly for the government to borrow from the markets to service its debt and cover costs.
Cyprus has turned to Russia for a 4 1/2-year, euro2.5 billion ($3.44 billion) loan agreement at a 4.5 percent annual interest rate which is much lower than markets are currently offering.
Moody's said Marfin's higher exposure to Greek government bonds compared with the other two banks makes it more likely that it would require a government cash infusion. The banks' combined exposure to Greek government bonds is estimated at around euro5 billion ($6.9 billion).
It said Marfin's losses would more than double as a result of last month's European debt deal for Greece which foresees a 50 percent write-off on money the country owes private bondholders.
That means Marfin would need more than euro1 billion ($1.37 billion) to meet minimum capital base requirements outlined by both the Cyprus Central Bank and the European Banking Authority. Moody's said raising that amount of money could prove difficult given the anxiety now gripping markets.
Moody's said the Bank of Cyprus and Hellenic Bank, which are both less exposed to Greece's weak sovereign bonds than Marfin, could cover their losses from the proposed debt deal write-off without needing external help. But the agency warned that further haircuts on Greek bond holdings can't be ruled out, piling on more pressure on banks. Another factor complicating things for the banks is the increasing difficulty of Greek households and businesses to repay loans, Moody's said.