Moody's rating agency cut Cyprus' credit grade by two notches on Thursday, citing worries about its banks' exposure to crisis-hit Greece, rising debt and a lack of economic competitiveness.
Moody's lowered its rating on Cypriot government bonds to A2 from Aa3 with a stable outlook, meaning no further downgrades are being considered.
The agency said a deterioration in Cyprus' public finances "is likely to be a lasting one," despite an improvement last year.
It said that without structural reforms to roll back a large government wage bill and social transfers which account for two thirds of state spending, long-term debt and deficit reduction will prove difficult.
"The Cypriot government does have a proven ability to increase revenues, but growth in public sector wages and social transfers are likely to outpace the government's ability to raise revenues, particularly given its commitment to remaining a low tax destination," Moody's said in a statement.
Cyprus' economy grew by 0.9 percent last year after a 1.7 contraction in 2009. The International Monetary Fund last week predicted growth of between 1.5 and 2 percent this year with favorable prospects for a continued upturn in 2012.
The agency said prolonged macroeconomic stress as a result of Cypriot banks' "substantial" exposure to Greece could affect the island's balance sheet. In aggregate, the three largest domestic banks have over 40 percent of their total lending in Greece, it said.
Another concern Moody's cited is the banking sector's large size relative to the economy. Bank assets total 650 percent of gross domestic product excluding foreign banks subsidiaries and branches, rising to 925 percent of GDP if these are included.
The island's long-term competitiveness is an additional, though less urgent, worry, Moody's said. Although wage increases have outstripped productivity gains in recent years and the tourism sector faces strong international competition, the agency said potential GDP growth remains fairly robust, giving the island time to address these challenges.
Moody's downgrade follows a similar move in November by Standard and Poor's, which cut the island's A plus grade to A with a negative outlook amid concerns over its public finances and exposure to Greece. Fitch Ratings is also reviewing Cyprus' finances for a possible downgrade over similar concerns.
The Cypriot government has tried hard to assure markets that it won't fall prey to the crisis that has hit neighboring Greece, which is receiving 110 billion euros ($151 billion) in rescue loans to keep it from defaulting on its debts.
Finance Minister Charilaos Stavrakis has said that the island is on track to bring the deficit below two percent of gross domestic product over the next two years.
Cyprus, a euro member, introduced a 175 million euro ($240.2 million) cost cutting and tax hike package in this year's state budget to fulfill a promise to European Union to halve a 6 percent deficit by 2012. The EU has a 3 percent deficit limit, though the rule has been broadly broken after countries' public debt was bloated by the financial crisis.
Among the cost cutting measures is a pledge to trim 3,000 jobs from a government work force of 53,000 in the country of 800,000.
Stavrakis said public debt — estimated at 60.6 percent for 2010 — is projected to rise marginally to 61.5 percent this year and stabilize at around 60 percent by 2013.
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