* Facing spike in international borrowing costs
Standard & Poor's cut Cyprus's credit rating by one notch on Friday and warned another cut was possible, deepening economic gloom for the island struggling with its worst peacetime disaster and mounting speculation it might be forced into an EU bailout.
Citing inconsistent commitments to spending cuts and risks of contagion from Greece's debt crisis, S&P said the outlook for its BBB-plus rating remained negative.
It was the second agency to cut Cyprus's rating this week, bringing it in line with Moody's Baa1 rating announced on Wednesday while Fitch remains one notch higher at A-minus.
Markets have been closely watching Cyprus for signs of stress for some weeks; yields on its international bonds have risen steadily this year and a July 11 blast which destroyed the island's largest power station triggering political turmoil has deepened fiscal woes.
Cyprus central bank governor Athanasios Orphanides has warned that without urgent remedial action Cyprus could be forced into an EU support mechanism.
Dismissing such a suggestion, the government says it has met its financing needs domestically this year but it is unclear if that factors in the cost of a blast damage bill, estimated anywhere between 1 and 3 bln euros. The top range of that estimate is equivalent to 17% of Cyprus's GDP.
Discussions on spending cuts are in disarray after opposition parties accused the government this week of backtracking on reform pledges, and Cyprus's cabinet tendered its resignation on Thursday to quell public anger at the blast, caused by munitions stored next to the power station.
The yield on a 10-year goverment bond issued to international investors in February 2010 was bid at 9.7% on Friday, up from 9.5% on Thursday and around 6.20% in early May. Cyprus is not a regular with international debt issues, and trading in its bonds is thin.
DEFICIT TARGETS UNLIKELY
Standard and Poor's said it believed Cyprus would struggle to meet its 2011 general government deficit target of less than 4.0% of GDP, and its 2012 target of 2%.
Missing those targets would exert pressure on general government debt which was anticipated to reach 80% of GDP by the end of 2011, after incorporating a 2.79 bln euro repo facility due to expire at the end of November 2012.
"Such a substantial rise in general government debt is likely to reduce the Cypriot government's capacity to back-stop its domestic banking sector, which in our view is vulnerable to the potential restructuring of government debt in Greece," Standard and Poor's said.
Cypriot banks' total exposure to Greece, which included bank, sovereign and loans in the Greek market, was equivalent to more than 160% of GDP. Although the Cypriot banking system was well capitalised, S&P said it anticipated potential losses in Greece could reduce current capital levels.
"Our baseline expectation is that the Cypriot government will not need to recapitalize the banks in the near future, but the ongoing uncertainty in the external environment increases the risk of this eventuality," S&P said.
