International credit ratings agency Moody's downgraded euro member Cyprus to junk status on Tuesday on heightened concerns over its banking sector's exposure to Greece.
The agency cut its rating on Cyprus by one notch to Ba1 and assigned a negative outlook, meaning that further downgrades are possible.
Moody's is the second agency to push the island nation's credit rating to junk after Standard & Poor's in January. Fitch rates Cyprus a notch above junk.
The downgrades have effectively shut Cyprus out of the international markets, prompting it to seek a euro 2.5 billion ($3.3 billion) low-interest loan from Russia to meet its financing needs for this year.
Moody's said that apart from their significant Greek government bold holdings, Cypriot banks' woes are compounded by their large Greek loan portfolios. It said those stresses on the banking system combined with weak private sector confidence and adverse external conditions will constrain the island's growth potential in the next few years and add to the fiscal challenges facing the government.
"Although the government seems well positioned to achieve significant progress this year, unfavorable economic conditions present implementation risks in 2013 and beyond," Moody's said.
Later on Tuesday, Moody's downgraded three Cypriot banks - Bank of Cyprus Public Co Ltd., Marfin Popular Bank Public Co. Ltd. and Hellenic Bank Public Co. Ltd. - further into junk territory.
The agency said that although Cypriot banks are looking to bolster their capital buffers through private sector investment, there is a "very material risk" that the government will have to step in to cover a likely shortfall that could amount to 5-10% of the island's gross domestic product. That could, in turn, deepen the island's debt load.
Cyprus finance minister Kikis Kazamias called the downgrade "unfair" because ratings agencies are factoring into their assessments possible losses that Cyprus may incur as a result of its banks' Greek exposure several years down the road.
The minister said he and Central Bank governor Athanasios Orphanides have drafted plans for the government to provide support to banks if it's deemed necessary.
Moody's said the scale of the downgrade was limited in light of the government's move to curb public spending and the discovery of substantial natural gas deposits off the island's shores.
The government hopes that current austerity measures will shrink the deficit to around 3% of Cyprus' gross domestic product. Longer-term, the gas discovery should also support the country's finances, though Moody's noted that Cyprus won't enjoy the full benefits for at least a decade.
Moody's said although the Russian loan helps Cyprus get by this year, there's uncertainty over how the government will secure some euro2 billion to meet its financing needs for 2013.
It said that it may turn to Europe's bailout fund for support, but the fact that the government turned to Russia for a loan suggests that it's reluctant to tap EU financing due to the strings attached to such a move. The three countries that have been bailed out — Greece, Ireland and Portugal — have had to enact harsh austerity measures in return for rescue loans.