NICOSIA, Cyprus (AP) — Ratings agency Standard & Poor's lowered Cyprus' sovereign debt grade one notch deeper into junk territory on Thursday and warned of further downgrades over concerns that the country's troubled banks will continue to strain public finances.
The downgrade, from BB+ to BB, highlights the battle the island nation of less than a million people faces to fix its sagging economy after becoming in June the fifth country to seek financial aid from its partners in the 17-country group that uses the euro.
Making the challenge even more daunting are projections that Cyprus' economy will contract by 1.5 percent this year and register no growth in 2013.
Cyprus needs the bailout primarily to recapitalize its top two commercial banks — the Bank of Cyprus and Cyprus Popular Bank — which took huge losses because of their exposure to debt-hobbled Greece, where they have expansive branch networks.
The government effectively took over Cyprus Popular Bank last month when it bought nearly €1.8 billion worth of its shares.
The country is in talks with the European Union and the International Monetary Fund on a rescue package that Standard & Poor's estimates will amount to €11 billion ($13.5 billion), or 60 percent of the country's GDP. Some €4.5 billion ($5.52 billion) of that sum will be needed to help banks, with the rest used to cover maturing debt and deficits until the end of 2014, according to the agency.
"However, even with official assistance — which we view as vital if Cyprus is to avoid default — we believe the government will remain in a weak fiscal position due to a banking system that has been unable to cope without government support as a result of its exposure to Greek customers," the agency said in a statement.
It estimates the country's debt will rise to over 105 percent of GDP by 2013, from 72 percent at the start of 2012.
The latest downgrade has little material impact on Cyprus' current financial situation, as all three major ratings agencies have already plunged the country's credit grade into junk status and the country has been unable to borrow from international markets since mid-2011 because of prohibitively high interest rates.
Cyprus has enough cash to pay its bills this year thanks to a low-interest, €2.5 billion ($3 billion) loan it clinched last year from ally Russia. It has asked Moscow for another €5 billion ($6 billion).
All eyes are now focused on the kind of rescue deal the government will negotiate amid fears that the country's potential creditors will exact the same painful austerity measures as seen in other bailed-out countries such as Greece.
Cyprus' massive public sector absorbs almost a third of government spending and workers have grown accustomed to large paychecks and benefits such as automatic, twice-yearly pay rises calculated according to inflation.
Trade unions and some politicians have already voiced opposition to measures that they say will hurt workers and push the economy further into recession.
Cypriot Finance Minister Vassos Shiarly said the European and IMF creditors — collectively known as the troika — are eyeing public sector cuts and tax hikes that "won't harm the economy."
Shiarly told state-run Cyprus News Agency this week that cuts "won't come from the electricity of telephone bills, but will come from large state expenditures which are nothing else but salaries and benefits."
He said the government doesn't agree with everything the troika is urging it to do and that more discussions are needed, without elaborating.
Troika officials are due back to the island in September, Shiarly said, with a deal expected to be signed either in September or October.
Standard & Poor's said if the government fully implements the conditions that come attached with a rescue deal, "it would likely be positive for Cyprus' creditworthiness as these would aim to reform public finances and reduce large economic imbalances."