The key driver for the rating action was the material increase in the likelihood of a Greek exit from the euro area, and the resulting increase in the likely amount of support that the government may have to extend to Cypriot banks.
The two-notch downgrade reflects Moody's assessment that this risk is exacerbated by the fact that the country's finances are already strained and access to the international markets is still denied.
Moody's decision to maintain Cyprus's sovereign bond ratings on review for further downgrade reflects the need to assess the substantial downside risks to the banking sector and the sovereign as a result of a Greek euro exit. These risks have the potential to rise in the aftermath of the Greek elections on 17 June 2012.
The key driver of Moody's two-notch downgrade of Cyprus's government bond rating is the significant deterioration in the country's outlook as a result of the material increase in the likelihood of a Greek exit from the euro area. The immediate result is a further increase in the likely amount of government support that the Cypriot banks may require due to their exposure to the Greek government and economy as well as the deterioration in domestic macro-economic conditions.
Moody's prior Ba1 rating for Cyprus incorporated an assumption that the Cypriot government would need to contribute capital support equivalent to around 5-10 per cent of GDP to the country's banks. The rating agency now expects this to be materially higher. For Cyprus Popular Bank alone, Moody's expects most, if not all, of the €1.8 billion in recapitalisation costs to be borne by the government, which will increase debt levels by just over 10 percentage points of GDP.
Moody's has reflected the increased risks emanating from the increased likelihood of a Greek exit in the ratings of the three largest Cypriot banks, two of which were downgraded on 12 June 2012, with all banks being placed on review for further downgrade. The close linkage between the government and the banking sector means that these increased risks for the banks may lead to much larger recapitalisation costs to the government, and Moody's needs to reflect these in the Cypriot sovereign's ratings.
See also Moody's downgrades two Cypriot banks, 12.6.12
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