Standard & Poors agency cut Cyprus' credit grade by one notch to BBB+, or three notches above junk status on Friday, and warned of a further downgrade on concerns that the country won't meet its deficit reduction targets for the next two years.
The downgrade comes on the back of a similar move on Wednesday by Moody's which cut Cyprus' credit rating by two notches, feeding speculation that the European Union member may be forced to seek a bailout.
S&P said despite ongoing talks between the government, opposition parties and labor unions on cost-cutting measures, the country will struggle to reduce a 2010 deficit of 5.3 percent of gross domestic product to 4 and 2 percent for 2011 and 2012 respectively.
Cyprus, which began using the euro in 2008, had pledged to the EU to meet those targets under a fiscal consolidation plan. But S&P said prospects of slashing the state payroll which takes up around a quarter of all government spending remain uncertain because of strong labor union influence.
Other structural reforms, including getting government workers to contribute to their pensions and raising the retirement age, are also facing delays.
The agency said those missed deficit targets will likely raise the government's debt load to an expected 80 percent of gross domestic product by the end of 2011 _ up by 19 percent from 2010.
Such a spike in debt will reduce the government's capacity to backstop the island's banking sector, which is vulnerable to the potential restructuring of government debt in Greece, it said.
S&P said the Cypriot banking sector's loans to Greek customers and holdings of Greek sovereign and bank debt are equivalent to over 160 percent of GDP.
It said although Cypriot banks are well capitalized, potential losses on their holdings of Greek sovereign a bank debt may reduce their current capital levels.
The agency said the Cypriot government won't need to support banks in the near future, but uncertainty in the external environment increases the risk.
S&P said it forecasts the current account deficit to just under 7 percent of GDP by the end of 2011. But that could be pushed even higher as a result of a deadly blast at a naval base that took out the island's main power station earlier this month.
Experts said it could cost euro700-800 million ($998 million-1.14 billion) to repair the station which supplied more than half the country's electricity and could take up to a year to fully bring back online.
The July 11 explosion of seized Iranian munitions that were being stored a few hundred meters from the power station also spawned a political crisis for President Dimitris Christofias.
Christofias' credibility has been seriously eroded among many Cypriots who see official negligence and incompetence as the root causes of the blast.
It has also thrown into question whether Christofias can push through tough spending cuts that S&P said are needed to avoid another downgrade.
Christofias on Thursday asked his Cabinet ministers to resign ahead of a reshuffle aimed at confronting the island's economic woes.
Cyprus' Central Bank Governor and European Central Bank Governing Council member Athanasios Orphanides last week warned that the blast may force Cyprus to seek a bailout if deep spending cuts aren't made swiftly.
S&P forecast medium-term growth for Cyprus to be 2 percent of GDP and any further deterioration of Greece's creditworthiness could push the island's growth prospects down further.
On Wednesday, Moody's cut Cyprus' credit rating by two notches from A2 to Baa1 over concerns about the blast's economic fallout, the combative political climate and the banking system's exposure to bailed-out Greece.