Cyprus faces a "material and rising risk" of defaulting on its sovereign debt, especially if the eurozone and International Monetary Fund do not come up with aid, rating agency Standard & Poor's said on Wednesday.
Crippled by its exposure to Greece, Cyprus needs 17 billion euros ($23 billion) from the eurozone to recapitalize its banks and to finance the government over the next three years.
S&P's comments come as the island gears up for a runoff presidential election on Sunday pitting a conservative in favor of a swift bailout deal against a Communist-backed candidate who supports a bailout but with fewer harsh austerity measures.
"We see at least a one-in-three chance that we could lower the Cyprus sovereign ratings again in 2013, for example if official financial assistance from the (European bailout fund) ESM and/or IMF is not forthcoming, leaving the Cypriot authorities few choices apart from to restructure its financial obligations," S&P's head of EMEA sovereign ratings Moritz Kraemer said in a report.
"We could also lower the ratings if we believe the (Cypriot) authorities are not able to fulfill the conditions that would be attached to an official assistance program."
S&P currently rates Cyprus at CCC+, well into non-investment grade "junk" bond territory, with a negative outlook.
Economists warn a financial crash in Cyprus could reignite the eurozone debt crisis. If the bloc does not come up with aid the resulting default would blow a gaping hole in promises made to investors that Greece's writedown last year was a one-off.
Cyprus asked for international aid eight months ago after its banks suffered huge losses on exposure to the restructuring of Greek sovereign debt and due to difficulties in accessing international capital markets shut to it because of fiscal slippage since mid-2011.
Its bid for aid has been delayed, however, by an incumbent leftist government slow to negotiate bailout terms, by worries among lenders over the island assuming a mountain of debt it may not be able to afford to repay, and by German charges that Cypriots are lax on tackling money-laundering.
Kraemer said that Greece, which S&P now rates at B- with a stable outlook, was not facing another default for the time being, and that any so-called "reprofiling" of its support program loans would not be classed as one by S&P.
"Subject to Greece meeting program conditions, we believe that eurozone member states would contemplate further improving official lending terms... This would be an effective write down of the Greek public debt stock," he said.
There was also a warning that Italy's drive to improve its finances could falter if elections this weekend result in a government lacking the clout to force through economic reforms.
Confidence in Italy has been shaken in the run-up to elections, after a strong campaign by former Prime Minister Silvio Berlusconi that has opened up the three-way race with Mario Monti and centre-left leader Pier Luigi Bersani.
It has threatened the prospects of a stable government emerging after the vote, the last thing Italy needs as it battles to repair an economy struggling after more than a decade of stagnant growth.
"Our negative outlook on the 'BBB+' sovereign rating on Italy reflects what we view as mostly downside risks to its reform policy agenda, overall economic outlook, and debt reduction plans," Kraemer said.
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