Cyprus has become the latest victim of the financial crisis in neighboring Greece after its credit rating was downgraded by ratings agency Fitch Tuesday.
Cyprus was downgraded to A- from AA- because of its exposure to the Greek debt crisis, with Cypriot banks assets exposed to Greek firms and households, Fitch said.
“The downgrade reflects the severity of the crisis in neighboring Greece and the risk this poses for the Cypriot banking system and consequently the public finances of Cyprus," said Chris Pryce, Director in Fitch's Sovereign Group.
The small island of Cyprus has a substantial banking system equivalent to approximately nine times its gross domestic product.
Its exposure to neighboring Greece is “a significant source of vulnerability” according to analysts at Fitch, who have had it on Rating Watch Negative since January 2011.
The island, officially known as the Republic of Cyprus and a member of the euro zone, has been historically the focus of dispute between Greek and Turkish Cypriots, with the majority population of Greek Cypriot origin.
Roughly one third of the Cypriot banking system's assets are booked as Greek exposure, including that of Greek subsidiaries based in Cyprus, including almost 14 billion euros ($20.1 billion) of Greek sovereign bonds and an estimated 5 billion euro of Greek bank bonds, according to Fitch.
Cypriot-owned banks, particularly the three major lenders, Bank of Cyprus, Marfin Popular Bank and Hellenic Bank, have also lent significant amounts to Greek companies and households through their substantial networks in Greece.
Fitch believes that these banks are relatively well placed to absorb the impact of a sovereign debt crisis in Greece that would cut 50 percent from the face value of Greek government bonds.
If this happens, the agency estimates that the cost of recapitalizing the banks to a tier one capital ratio of 10 percent would be around 2 billion euros, or 11 percent of GDP, only part of which might have to be met by the state.
In a more severe stress test, where a Greek sovereign default led to non-performing loans rising to 25 percent, Fitch estimates that the cost of recapitalizing the banks could rise to 25 percent of GDP, which would have to be supported more by the state.
Fitch believes that the Cypriot government would be able to provide effective support to Cypriot banks in a stress test of this magnitude.
At 61 percent of GDP, Cypriot general government debt is not high by euro area standards although it exceeds the Maastricht-imposed limit by one percentage point.
The cost of providing financial sector support could materially alter the government's debt profile and drag down its sovereign ratings.
Fitch does not rule out additional funding pressures arising for banks, including subsidiaries of Greek banks. However, the agency believes that the European Central Bank would provide liquidity support in such an environment, thereby preserving financial stability in Cyprus.