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Rating Action:

Moody's downgrades Cyprus's government bond ratings to Caa3 from B3; negative outlook

10 Jan 2013

London, 10 January 2013 -- Moody's Investors Service has today downgraded Cyprus's government bond rating to Caa3 from B3, and the outlook on the rating is negative. The rating action concludes the review for possible downgrade initiated on 16 November 2012. Cyprus's short-term government bond rating of Not Prime has been affirmed.

The key driver of today's rating action is the anticipated rise in the Cypriot government's debt burden, driven principally by the increased recapitalisation needs of its banking system following distressed exchanges on Greek government debt and rising delinquencies on loans to Greek and Cypriot obligors. Given that the resulting increase in the debt burden is likely to be unsustainable, Moody's believes there is a significantly increased likelihood that the Cypriot government may eventually default outright or press for a distressed exchange, although Moody's base case does not assume a default or distressed exchange in 2013.

The negative outlook assigned to the rating reflects Moody's view that the situation could significantly deteriorate over the next 12 to 18 months because of three factors: (1) ongoing liquidity concerns; (2) uncertainty about the exact size of the necessary bank recapitalisations, which may exceed the rating agency's current projections; and (3) uncertainty about the upcoming finalisation and signing of a Memorandum of Understanding (MoU) with the International Monetary Fund, the European Union and the European Central Bank, also collectively known as the Troika.

RATIONALE FOR DOWNGRADE

The main driver of Moody's three-notch downgrade of Cyprus's government bond rating is the further increase in the amount of government support that the rating agency believes Cypriot banks are likely to require. Previously, Moody's forecasts of bank recapitalisation costs had not included the credit cooperative sector. However, our updated stress test analysis suggests that the recapitalisation cost for the three largest banks is higher than originally anticipated which, when combined with the likely needs of the cooperative sector, translates into a bank recapitalisation cost of about EUR 10 billion, which equates to over 50% of GDP. This estimate is consistent with the Troika's provisional bank recapitalisation estimates. Moody's has therefore incorporated its higher forecasts for bank recapitalisation costs in its revised projections of the Cypriot general government debt for 2013. However, the rating agency may, over time, undertake further upward revisions of these recapitalisation cost estimates given the rapid ongoing deterioration of the three largest Cypriot banks' asset quality, as reflected in the rise in non-performing loans to 26% in September 2012 from 19% in March 2012.

As a result of these changed forecasts and assumptions, Moody's currently estimates that the capital needs of the Cypriot financial sector are likely to push the sovereign's debt-to-GDP ratio to 150% in 2013 -- which would be one of the highest levels in Moody's rating universe. More importantly, Moody's believes that these debt levels could continue to rise to above 154% by 2015 in view of the uncertainties regarding the cost of recapitalising the banks and the implementation risks facing the country's fiscal consolidation plan given the uncertain depth and length of the economic downturn. This upward adjustment in Moody's forecast for Cyprus's debt levels has in turn led to an assessment of a heightened probability of default, given that debt levels of this magnitude are unlikely to be sustainable for a small country with very weak expected nominal GDP growth.

Moody's recognises that there is a strong political will among euro area countries to avoid private sector involvement (PSI) and/or distressed exchanges for any country in the monetary union, notwithstanding Greece's default. Moody's also acknowledges that the Cypriot banking system's exposure to its own government's debt would limit the debt relief that the sovereign could obtain from a restructuring. However, even though a debt restructuring would increase the required bank recapitalisation costs, Cyprus could obtain some debt relief through a restructuring with a large haircut. Moreover, in Moody's opinion, there is a probability of around 50% that the sheer size of Cyprus's anticipated debt load will eventually compel the authorities to pursue every avenue for debt reduction, including PSI. Given the very high projected debt burden relative to the size of the economy, Moody's expects investors to record large losses in such an event, and that a Caa3 rating is therefore warranted.

RATIONALE FOR NEGATIVE OUTLOOK

Moody's has assigned a negative outlook to Cyprus's Caa3 government bond rating because of three significant uncertainties regarding events that might prompt a rating downgrade and a possible default over the near term:

1.) Liquidity concerns. Although Moody's base assumption continues to be that access to short-term funding will remain sufficient for the Cypriot government to meet its funding needs, the rating agency notes that, in the absence of a disbursement from the Troika, the government may face a severe crisis.

2.) Bank recapitalisation needs. The government has employed a US asset manager, Pimco, to estimate the banks' recapitalisation needs. Until its report is finalised later in January, there will be lingering uncertainty about the amount of support that the government will need to provide to Cyprus's banking sector in 2013.

3.) Progress of negotiations with the Troika. While Moody's believes that the current agreement in principle between Cyprus and the Troika on an MoU represents significant progress, the rating agency notes that the finalisation of an agreement and disbursement of funds have been delayed and that an assessment of debt sustainability has also not been completed. Moody's base assumption continues to be that the Cypriot government will be able to reach an agreement with the Troika that will result in the provision of official assistance to the Cypriot government until at least 2016 -- however, questions about debt sustainability remain central to Moody's views on the probability of a default event for Cyprus.

WHAT COULD CHANGE THE RATING UP/DOWN

Moody's considers a material upward movement in Cyprus's government bond rating to be unlikely as long as debt levels continue to rise and remain at very high levels. The magnitude of the government's fiscal challenge is unlikely to change materially even following an agreement on conditionality because of the sheer size of the financial support that is needed for the banking sector.

The rating agency says that further downward movement in Cyprus's sovereign rating would be likely if the likelihood of default were to become more certain. Moreover, a downgrade would be likely if a Greek exit from monetary union were to become more probable.

COUNTRY CEILINGS

As a consequence of today's rating action on the Cypriot sovereign, Moody's has today also lowered the maximum rating that can be assigned to a domestic issuer in Cyprus, including structured finance securities backed by Cypriot receivables, by three notches to Caa1 from B1. The lower ceiling reflects the increased risk of economic and financial dislocations. The short-term foreign-currency country and deposit ceilings remain at Not Prime.

Cyprus's adjusted country ceiling reflects Moody's assessment that the risk of economic and financial instability in the country has increased. The weakness of the economy and the sovereign's lack of access to international markets constitutes a substantial risk factor to other (non-government) issuers in Cyprus as income and access to liquidity and funding could be sharply curtailed for all classes of borrowers. Moody's cannot exclude a further deterioration in the financial sector, which could lead to potentially severe systemic economic disruption and reduced access to credit. Finally, the ceiling reflects the risk of Cyprus's exit from the euro area and a redenomination in the event of a default by the sovereign. If the Cypriot government's rating were to fall further from its current Caa3 level, Moody's might reassess the country ceiling and lower it at that time. Moody's would also reassess the country ceiling in the event of an upgrade of the Cypriot government's bond rating.

Moody's country ceilings capture externalities and event risks that arise unavoidably as a consequence of locating a business in a particular country and that ultimately constrain domestic issuers' ability to service their debt obligations. As such, the ceiling encapsulates elements of economic, financial, political and legal risks in a country, including political instability, the risk of government intervention, the risk of systemic economic disruption, severe financial instability risks, currency redenomination and natural disasters, among other factors, that need to be incorporated into the ratings of the strongest issuers. The ceiling caps the credit rating of all issuers and transactions with material exposure to those risks -- in other words, it affects all domestic issuers and transactions other than those whose assets and revenues are predominantly sourced from or located outside of the country, or which benefit from an external credit support.

The principal methodology used in this rating was Sovereign Bond Ratings published in September 2008. Please see the Credit Policy page on www.moodys.com for a copy of this methodology.

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 no 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, public information, and confidential and proprietary Moody's Investors Service information.

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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.

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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.

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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
VP - Senior Credit Officer
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 government bond ratings to Caa3 from B3; negative outlook
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