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Rating Action:

Moody's downgrades Cyprus's bond ratings to Baa3/P-3, on review for further downgrade

Global Credit Research - 04 Nov 2011

London, 04 November 2011 -- Moody's Investors Service has today downgraded Cyprus's government bond ratings to Baa3 from Baa1 and placed the ratings on review for further possible downgrade. The rating agency has also downgraded Cyprus's short-term rating to Prime-3 from Prime-2 and placed it on review for further possible downgrade.

The key drivers for today's rating announcement are:

1. The high likelihood that the Cypriot banking system will require state support in 2012 as a result of the large expected write-downs on its exposures to Greek government bonds. This state support will have a significantly negative impact on the government's debt metrics. The full extent of required state support for the Cypriot banking system could increase further, given the substantial downside economic and financial risks in Greece.

2. The Cypriot government's loss of international market access and the resulting likelihood that the government will need to seek emergency funding from official sources.

3. Cyprus's weaker-than-expected institutional capacity to approve and implement the budgetary and structural changes that are needed to correct the government's rising debt trajectory and improve the longer-term sustainability of its public finances.

Moody's believes that the combined impact, and the links between, these three factors on the government's balance sheet is, at best, consistent with the lower end of the Baa rating range. The structural rigidities in the government budget are not being decisively addressed, increasing risks to the fiscal consolidation plans. These vulnerabilities have also substantially reduced the government's ability to absorb an increase in debt stemming from the crystallisation of contingent banking liabilities. The potential size of these liabilities, along with the rapid deterioration of conditions in Greece, and the government's weak response to these adverse developments have resulted in a loss of international market access.

The decision to maintain the ratings on review for further downgrade reflects the need to assess the substantial downside risks to the government's fiscal performance, the Cypriot banking sector, and the state's future funding plans. A rising probability that these risks will crystallise would likely cause the government to lose its investment grade debt rating.

RATINGS RATIONALE

The first driver of Moody's two-notch downgrade is the very high likelihood that the Cypriot government will need to contribute to the recapitalisation effort of the banking system. In accordance with the revised deal on greater public sector involvement (PSI) in Greece, announced on 27 October, the losses on Greek government bonds are now more than double the levels stipulated under the 21 July PSI deal. This will cause the system to become under-capitalised. Given the high risk that the banking system will be unable to raise the necessary capital in the private sector, there is a strong likelihood that it will require assistance from the Cypriot government. Consequently, Moody's debt calculations for the sovereign now assume a minimum of EUR1 billion in government-financed recapitalisation costs; in total, Moody's base case is that the general government debt-to-GDP ratio will rise by 5-10 percentage points as a result of bank recapitalisations.

The second driver of the downgrade is the Cypriot government's loss of international market access and the resulting risk that the government will need to seek emergency funding from official sources, such as the EFSF. As is the case for a number of countries in the euro area, the difficulties that Cyprus has faced over the past year are likely to have a long-lasting impact on investors' perceptions of the riskiness of government debt, and therefore the sovereign's medium-term funding costs. Moody's also believes that, within the euro area context, the conditionality that is associated with official funding places the creditworthiness of supported sovereigns under pressure because a precedent has now been set with Greek PSI. (please refer to Moody's Special Comment entitled "Euro Area Summit -- Summary of Key Credit Implications", 28 October 2011). Moody's notes that the pledged bilateral loan from Russia should satisfy the bulk of Cyprus's funding needs for 2012 and address any immediate liquidity pressures. Moreover, the country's domestic market remains open, but at a higher cost.

The third driver of today's downgrade is the Cypriot government's weaker-than-expected capacity to implement, in a timely fashion, the budgetary and structural changes that are urgently needed to correct the government's rising debt trajectory. Recent developments have also illustrated the government's inability to respond decisively and credibly to shocks such as the destruction of the Vasilikos power plant on 11 July 2011, which was a very disruptive event from a political, economic and financial standpoint. In the months since the plant's destruction, the Cypriot government has faced a number of delays in passing fiscal consolidation measures, and structural fiscal reform measures appear to be playing a smaller role than was previously envisaged. Moody's is concerned that conflicts between the various political parties, as well as the trade unions, could impede fiscal consolidation and structural reform at a time of weakening economic conditions both in Cyprus and in its major trading partners.

FACTORS TO BE CONSIDERED IN THE REVIEW

Moody's review of Cyprus's sovereign rating will focus primarily on the recapitalisation needs of the Cypriot banking sector. The situation in Greece remains highly volatile and the magnitude of losses that the Cypriot banks will experience on their Greek government bond portfolio and lending book could require further government-financed capital injections. During the review period, Moody's expects to receive additional information about the capital requirements of all Cypriot banks. This should allow the rating agency to refine its estimates of the likely extent of the government's contribution to this effort.

The review will also focus on structural changes to key expenditure areas such as public sector pensions, public sector wages and social transfers. The second package of fiscal consolidation measures, which was sent to parliament on 13 October, contains some means-testing for social transfers, although there is probably more scope to cut these expenditures further. The government has also committed to delivering reforms to address the cost-of-living adjustment for public-sector workers; however, given trade union pressures, this will be difficult to achieve, but will ultimately be important for improving the sustainability of the Cyprus's public finances, which is a particularly urgent concern given the additional fiscal pressures that will be generated by stressed macroeconomic conditions.

These two factors will determine the extent of the Cypriot government's need for external support from official sources, such as the EFSF (or the subsequent European Stability Mechanism (ESM)) for funding and if so for how long. In Moody's view, a reliance on the EFSF or ESM for funding increases the risk of burden-sharing with private sector creditors.

The principal methodology used in this rating was Moody's "Sovereign Bond Ratings", which was published in September 2008 and is available on www.moodys.com.

REGULATORY DISCLOSURES

For ratings issued on a program, series or category/class of debt, this announcement provides relevant regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series or category/class of debt or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides relevant regulatory disclosures in relation to the rating action on the support provider and in relation to each particular rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides relevant regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

The rating has been disclosed to the rated entity or its designated agent(s) and issued with amendment resulting from that disclosure.

Information sources used to prepare the rating are the following : parties involved in the ratings, parties not involved in the ratings, and public information.

Moody's considers the quality of information available on the rated entity, obligation or credit satisfactory for the purposes of issuing a rating.

Moody's adopts all necessary measures so that the information it uses in assigning a rating is of sufficient quality and from sources Moody's considers to be reliable including, when appropriate, independent third-party sources. However, Moody's is not an auditor and cannot in every instance independently verify or validate information received in the rating process.

Moody's Investors Service may have provided Ancillary or Other Permissible Service(s) to the rated entity or its related third parties within the two years preceding the credit rating action. Please see the special report "Ancillary or other permissible services provided to entities rated by MIS's EU credit rating agencies" on the ratings disclosure page on our website www.moodys.com for further information.

Please see the ratings disclosure page on www.moodys.com for general disclosure on potential conflicts of interests.

Please see the ratings disclosure page on www.moodys.com for information on (A) MCO's major shareholders (above 5%) and for (B) further information regarding certain affiliations that may exist between directors of MCO and rated entities as well as (C) the names of entities that hold ratings from MIS that have also publicly reported to the SEC an ownership interest in MCO of more than 5%. A member of the board of directors of this rated entity may also be a member of the board of directors of a shareholder of Moody's Corporation; however, Moody's has not independently verified this matter.

Please see Moody's Rating Symbols and Definitions on the Rating Process page on www.moodys.com for further information on the meaning of each rating category and the definition of default and recovery.

Please see ratings tab on the issuer/entity page on www.moodys.com for the last rating action and the rating history.

The date on which some ratings were first released goes back to a time before Moody's ratings were fully digitized and accurate data may not be available. Consequently, Moody's provides a date that it believes is the most reliable and accurate based on the information that is available to it. Please see the ratings disclosure page on our website www.moodys.com for further information.

Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

Sarah Carlson
Vice President - Senior Analyst
Sovereign Risk Group
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Bart Oosterveld
MD - Sovereign Risk
Sovereign Risk Group
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

Releasing Office:
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Moody's downgrades Cyprus's bond ratings to Baa3/P-3, on review for further downgrade
No Related Data.

 

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