* Economic sentiment drops in July *
Moody's cut Cyprus's credit rating by two notches on Wednesday, saying an energy crisis and fallout from the island's banks' exposure to Greek debt risked derailing fiscal reforms, and a further downgrade was possible.
The rating agency also cut its growth outlook for Cyprus, to zero this year and to 1% in 2012, due in part to reduced power production after the Vassilikos plant, which generated 53% of Cyprus's electricity output, was destroyed in a blast on July 11.
Moody's said its new Baa1 rating — three notches above junk — was "skewed to the downside", suggesting a further cut if authorities watered down or significantly delayed recently announced reforms to government finances.
"The Baa1 rating does incorporate an assumption that something resembling those reforms does eventually get legislated and implemented," Moody's senior analyst Sarah Carlson told Reuters.
Downward ratings pressure could also be exerted if problems in the Cypriot banking sector – holding between 4.5 and 5 bln euros of Greek debt – were to require a substantial injection of government money, Moody's said.
It last downgraded Cyprus in February, when it cited the same structural and Greece-related concerns. Rival agencies Fitch and Standard and Poor's, which have also downgraded Cyprus this year, both rate the country at A-.
Moody's said it would consider a rating upgrade if Cyprus introduced sweeping structural reforms in its social transfers system and public sector wage bill, and recorded significant and lasting cost savings.
BLAST IMPACT
Since the blast, Cyprus's state-owned electricity authority (EAC), which has an effective monopoly on power generation on the island, has introduced rolling power cuts. Economists have estimated the cost of the blast and its consequences at at least 1 bln euros, a significant slice of the island’s 17.4 bln euro economy.
Cyprus launched a plan on July 1 to cut spending in the civil service and scrap a number of state-owned organisations. But that programme and anticipated further measures to deal with the fallout from the blast face significant political hurdles.
On Tuesday, a number of parties accused the government of backtracking on reforms because they feared an angry backlash from the powerful labour unions.
The two parties in the centre-left government do not have an absolute majority in parliament to push reforms through so any measures have to be adopted by consensus.
Moody's said that if any of the plans were watered down or delayed significantly that could prompt a further downgrade. An increasingly fractious political climate added to implementation risks over the government's new fiscal plans, it said.
"There are so far no short-term measures to compensate for the plant's destruction," Carlson said. "We think this will mute the government's planned range of structural measures that have been designed to improve fiscal sustainability over the medium term."
SENTIMENT DROPS
Economic sentiment dropped in July, a publicly funded survey showed, without however factoring in the effect of a massive munitions blast which triggered an energy crisis this month, disrupting business.
The economic sentiment indicator prepared by the University of Cyprus fell 0.9 points month-on-month to 83 points in July. Most of the survey had been concluded by July 8, the University's Economic Research unit said.
The island's exposure to debt-laden Greece and the financial impact of the munitions blast have raised concerns in financial markets that Cyprus might need to follow Greece and other peripheral euro zone countries and seek a bailout.
The decline in economic sentiment in July reflected a deterioration in the outlook among consumers on domestic and national finances and concerns about unemployment over the next 12 months, the university said.
Unemployment rose to 7.4% in May, from 7.2% in April and 6.4% in May 2010, according to Eurostat.
