UPDATE 2-Moody's downgrades Cyprus to Caa3, warns may cut more

NEW YORK, Jan 10 (Reuters) - Moody's Investors Service slashed Cyprus's rating three notches on Thursday on an expected rise in the Mediterranean country's debt burden and warned it could cut the rating again.

Moody's cut Cyprus to Caa3 with a negative outlook from B3, saying in a statement the country's debt burden was set to rise because of capital needs for banks hurt by exposure to crisis-wracked Greece.

"We think that there's a higher likelihood that the government may default outright or press for a distressed exchange," said Sarah Carlson, a senior credit officer with Moody's sovereign risk group.

That probability is now about 50 percent, she said, although it is not Moody's base case scenario for 2013.

"We had never published a probability before, I think because right now we're in the part of the ratings space where probabilities become quite high," Carlson added.

Last June, the island became the fourth euro zone state to apply for a financial rescue from the European Union and the International Monetary Fund after its banks suffered huge losses on the EU-approved writedown on Greece's debt.

The bailout could reach 17 billion euros, virtually equivalent to Cyprus' entire economic output.

But a bailout for the country is unlikely to come swiftly, complicated as it is by worries about debt sustainability.

Nor is Cyprus likely to see an improved sovereign rating as long as its debt burden remains outsized, Carlson said.

Even after a bailout deal is finalized, the "sheer size" of the support needed for banks will mean the government's budget challenge "is unlikely to change materially," she said.

Standard & Poor's rates the country CCC-plus with a negative outlook. Fitch rates Cyprus BB-minus, also with a negative outlook.