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Standard & Poor's warns island is facing a 'material and rising' risk

CYPRUS faces a "material and rising risk" of defaulting on its sovereign debt, especially if the eurozone and International Monetary Fund do not come up with aid, rating agency Standard & Poor's said yesterday.

"We see at least a one-in-three chance that we could lower the Cyprus sovereign ratings again in 2013, for example if official financial assistance from the (European bailout fund) ESM and/or IMF is not forthcoming, leaving the Cypriot authorities few choices apart from to restructure its financial obligations," S&P's head of EMEA sovereign ratings Moritz Kraemer said in a report.

S&P's comments came as the island gears up for a run-off presidential election on Sunday pitting DISY chief Nicos Anastasiades, who is in favour of a swift bailout deal against the AKEL-backed Stavros Malas who supports a bailout but with fewer harsh austerity measures.

"We could also lower the ratings if we believe the (Cypriot) authorities are not able to fulfill the conditions that would be attached to an official assistance programme."

S&P currently rates Cyprus at CCC+, well into non-investment grade "junk" bond territory, with a negative outlook.

Cyprus asked for international aid eight months ago after its banks suffered huge losses on exposure to a restructuring of Greek sovereign debt and due to difficulties in accessing international capital markets shut to it because of fiscal slippage since mid-2011.

Cyprus could need an estimated €17.5 billion from the eurozone to recapitalise its banks and to finance the government over the next three years.

Though the final figure has not yet been agreed, as Cyprus appears to object the amount needed for bank recapitalisation – €10 billion, the EU and the IMF have expressed concern over the island’s debt burden after the bailout.

The IMF has reportedly asked for Cypriot banks to be recapitalised directly by the European Stability Mechanism and or a debt restructuring of either sovereign or bank debt. 

The idea of deposit haircuts has also been floated.

Financial services giant J.P. Morgan views the recent rhetoric as “mostly negotiation tactics.”

“The IMF wants to force a more pro-active commitment from the eurozone (it is also pushing for bank recap relief in Ireland), and both the IMF and eurozone want Cyprus to agree to more aggressive reforms and collateral commitments,” a J.P. Morgan report said earlier this month. “Similarly, the eurozone wants to ensure Russia’s participation in the bailout, given Russia’s deep economic ties to Cyprus. Policymakers can only reach these goals by raising the political heat.”

J.P. Morgan suggested that no one would be willing to risk the progress made in the eurozone’s periphery over the past few months, adding that there were enough market-friendly solutions to make Cypriot debt sustainable.

“Thus, our basecase expectation is that Cyprus and the troika reach agreement based on a combination of market-friendly measures including ledging of gas reserves, a privatisation programme and subordinate bank debt burden-sharing. We give our benign scenario 70 to 80 per cent probability,” it said.

The benefits of harsher options such as sovereign debt write-down or deposit haircut were modest relative to potential contagion risk and EU policymakers were likely to opt for the risk-averse solution, J.P. Morgan added.