Fitch Downgrades Cyprus to BB+ from BBB-, Outlook Negative

Fitch Ratings has downgraded Cyprus' sovereign bond to 'BB+' from 'BBB-', citing an increased amount of money - up to six billion euros - needed to bail out the banks on its exposure to Greek debt.

The government will need 1.8 billion euros or 10 percent of GDP to save Laiki Bank, and Fitch says that Cypriot banks will require 'further substantial injections of capital', possibly up to six billion euros more. While most of the increase in banking sector losses is associated with Cypriot banks' Greek exposure, domestic Cypriot loans have also seen an increase in non-performance, said Fitch.

The Cypriot economy has contracted and unemployment has risen, so even assuming that Greece remains in the eurozone, Cypriot banks will have to bear significant further loan losses as the Greek economy continues to contract over the medium term as well as the deterioration in domestic asset quality, said Fitch.

The scope for further capital-raising from the private sector is limited and the capital will have to be provided by the government, sending its spending to over 100 percent of GDP, said the agency.

"The budget has underperformed government expectations in the first half of 2012. Though corrective measures are likely to be introduced, the official deficit/GDP target of 3% is likely to be missed and is forecast by Fitch to reach 3.9% of GDP," said the agency.

Fitch judges the near-term liquidity risk faced by the sovereign to be low. Bond maturities are moderate in 2012 and 2013 and fiscal financing is secure for the remainder of 2012, said the agency. In 2013 the government has EUR2.25bn of refinancing needs, including a EUR1.5bn EMTN redemption in July 2013. Fitch expects Cyprus to secure a bilateral loan, likely from the Russian Federation ('BBB'/Stable), which will be sufficient to cover the gross budgetary funding requirement up to end-2013.

However, the agency also expects that Cyprus will have to secure a loan from the EFSF/ESM to fund the broader recapitalisation of the banking sector. The lack of market access to affordable term finance underscores the constrained financing flexibility of the sovereign to respond to adverse shocks.

The near to medium-term economic outlook for Cyprus is weak. Fitch expects the economy to stagnate this year and next and thereafter to recover only slowly as macroeconomic imbalances unwind and the headwinds from the on-going eurozone and Greek crises persist.

However, as these imbalances are resolved, Fitch's expects the underlying fundamentals of the economy to support a resumption of economic growth over the medium-term. Combined with still moderate effective interest cost and on the assumption that the government reduces the budget deficit below 3% of GDP in 2013 and beyond, government debt sustainability is within reach, said Fitch.

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