Fitch downgrades Cyprus over threat of Greek contagion

Fears that the effects of the sovereign debt crisis in Greece may be felt in neighbouring Cyprus prompted rating agency Fitch, on Tuesday, to downgrade the island's credit rating three notches.

Fitch cut its long-term credit rating of Cyprus from AA- to A-, four notches above non-investment grade. The agency also placed the country on negative outlook. "The downgrade reflects the severity of the crisis in neighbouring Greece and the risk this poses for the Cypriot banking system, and consequently the public finances of Cyprus," said Chris Pryce, the director in Fitch's Sovereign Group.

Cyprus's banking sector has weathered the financial crisis relatively well, due to its conservative balance sheet management and careful supervision, which has shielded the banking sector from pressures that are prevalent in many other countries. However, Greece continues to be a source of vulnerability in the Cypriot banking sector, with roughly one third of the banking system's assets booked as Greek exposure, including €14 billion ($20 billion) of Greek sovereign bonds and an estimated €5 billion of Greek bank bonds.

Fitch said most of the Greek-related exposure was held by the three major Cypriot banks: Bank of Cyprus, Marfin Popular Bank and Hellenic Bank. The agency said that although the banks were relatively well placed to absorb the impact of a sovereign debt crisis in Greece, the cost of recapitalising the banks in response to a Greek default would necessitate "extensive sovereign support".

Concerns about contagion have intensified in recent weeks amid concerns over Greece's fiscal sustainability. While some European leaders, such as Jean-Claude Juncker, Luxembourg's prime minister and head of the eurogroup, have said a "soft restructuring", or reprofiling, of Greece's debt should be considered, others have dismissed any suggestion of a restructuring, fearing it could lead to contagion spreading to peripheral countries. Jens Weidmann, the president of the Bundesbank, on May 20 said a reprofiling of Greek bonds risked creating contagion to other countries in the euro area. "A prolongation of Greek government bonds in an environment of prevailing strong doubts about the sustainability of public finances would make it impossible to accept them as collateral for refinancing operations under the existing rules of the Eurosystem's collateral framework," Weidmann said.