Fitch ratings agency on Tuesday cut Cyprus' sovereign credit rating by three notches and warned of another possible downgrade because of its banking sector's large exposure to debt-laden Greece.
"The downgrade reflects the severity of the crisis in neighboring 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 rating was lowered to rating from AA- to A-.
Fitch said around one-third of the banking system's assets _ which in total are about nine times the euro country's gross domestic product _ is booked as exposure to Greece's financial system. That exposure includes almost euro14 billion ($20 billion) of Greek sovereign bonds and some euro5 billion ($7 billion) in Greek bank bonds.
The agency noted the island's three largest banks _ Bank of Cyprus, Marfin Popular Bank and Hellenic Bank _ hold most of that Greek exposure but that they could absorb a severe reduction, or haircut, in Greek bond value of 50 percent.
Under that scenario, Cypriot banks would need around euro2 billion, or 11 percent of GDP, to be recapitalized.
Many investors don't believe Greece will be able to avoid reneging on its debts despite last year's euro110 billion ($157 billion) rescue package from the EU and IMF. The European Central Bank, however, has ruled out any such move.
Fitch said the Cypriot government "would be willing and able" to offer a financial backstop to Cypriot banks since government debt now standing at 61 percent of GDP is not high by eurozone stands.
Although the cost of providing such support would negatively impact the island's sovereign debt ratings, the European Central Bank would step in with additional liquidity to preserve the island's financial stability, Fitch said.
The agency's downgrade of Cyprus follows similar moves by rival ratings agencies Moody's and Standard & Poor's in recent months based on similar concerns.
The island's Central Bank and finance ministry said in seperate statements that they disagreed with Fitch's analysis. The ministry said the banking system remains robust with high liquidity levels and strong capitalization, enabling it to withstand any "theoretical scenario of Greek debt restructuring."
The Central Bank also urged the government to put public finances back in order to dispel any concerns by analysts.
The successive downgrades have prompted the Cypriot government to take some precautionary measures.
Last week, Finance Minister Charilaos Stavrakis said the island will raise its borrowing capacity from euro6 billion to euro9 billion ($12.8 billion) this year so that it can quickly tap foreign lenders for large amounts of money to support organizations that may run into trouble.
Legislators last month approved a tax on bank deposits aimed at shoring up public finances and creating a stability fund to buttress the financial system's credibility.