UPDATE 2-Cyprus central bank sees shallower 2014 recession than forecast
* Central bank governor sees 4 pct economic contraction in 2014
* Says commercial banks prudent to raise capital before stress tests
* Says expects them to pass bank tests (Adds quotes, detail)
NICOSIA, June 25 (Reuters) - Cyprus's economy could contract less this year than the 4.2 percent expected by the euro zone country's bailout lenders, its central bank governor said on Wednesday.
The European Union and International Monetary Fund, which will lend Cyprus 10 billion euros under a year-old rescue deal, revised the projected drop in output lower last month from an earlier estimate of 4.8 percent.
At a news conference, central bank governor Chrystalla Georghadji cited data showing an annual decline in first quarter output of 4.1 percent compared to a 5 percent contraction in the quarter before.
"Based on that assessment, the troika's projection for a 4.2 percent decline in growth for the full year is rather pessimistic," she said.
"We would expect it to be around 4.0 percent."
Since its March 2013 rescue, under which the island nation was forced to shut down a loss-making bank and impose losses on depositors in another lender, Cyprus's economy has proved more resilient than many had expected.
Last week, it made the swiftest return to financial markets of any bailed-out country, selling a 750 million euro five-year bond yielding 4.8 percent.
Georghadji, who also represents Cyprus on the governing council of the European Central Bank, said the island would fully dismantle capital controls imposed at the time of the bailout when confidence in the banking sector was restored.
Domestic controls were fully dismantled in May, but controls still exist in transactions with the outside world.
Efforts to shore up the financial industry, wrecked by its exposure to Greek debt and by the rescue plan, were beginning to yield results, she told the news conference in Nicosia.
Georghadji later said commercial banks were wise to try to raise capital ahead of euro zone-wide stress tests later this year for which they should be "absolutely prepared".
"A capital issue would be a prudent move for them to move towards the stress tests reinforced," she told journalists, adding that better buffers against future losses for commercial banks could also help hasten the removal of capital controls.
Bank of Cyprus, which recapitalised last year by turning a percentage of deposits at the bank into equity and some of its biggest clients into shareholders, said on Tuesday its board would discuss capital issues and funding at a meeting on June 26.
It is one of four Cyprus-based banks that will undergo the stress tests, among 134 in the euro zone. The others are Hellenic Bank, Russian Commercial Bank and the Cooperative Bank.
The Co-Op has already received a 1.5 billion euro cash injection from the government, drawn from bailout funds.
"I'm certain that with prudence and the measures being taken the banks will pass these stress tests," she said. (Editing by Catherine Evans)