* Agency cuts island's rating by 2 notches to Baa1
* Says new rating factors in fiscal reforms
* Says further cut possible; also cites Greek debt holdings
* Cuts Cyprus growth view to zero this year, 1 pct in 2012
* 10-yr bond yield spikes to 9.5 percent
(Recasts, adds detail)
By Michele Kambas
NICOSIA, July 27 (Reuters) - Moody's cut Cyprus's credit rating by two notches on Wednesday and warned another downgrade was possible, highlighting an energy crisis and exposure to Greece that threaten to tip the island into fiscal meltdown.
Markets have trained their sights on the east Mediterranean nation as a possible fourth recipient of a euro zone bailout since a huge explosion destroyed its largest power plant, and political wrangling now risks derailing much-needed economic reforms.
If the reforms were significantly delayed or watered down, the country's debt would be marked down again from its new grade of Baa1 to no more than two steps above junk status, the rating agency said.
The yield on Cyprus' benchmark 10-year bond issued in February 2010 spiked to 9.5 percent on Wednesday following the Moody's statement, up from 8.9 percent a week ago and from around 6.20 percent in early May.
"The Baa1 rating does incorporate an assumption that something resembling those (fiscal) reforms does eventually get legislated and implemented," Moody's senior analyst Sarah Carlson told Reuters.
Cyprus, one of the euro zone's smallest members, has seen its external borrowing costs spiral in the past twelve months as ratings agencies issued downgrades in response to its banks' exposure to Greece and the lagging reforms.
The July 11 blast at the Vassilikos plant, which wiped out 53 percent of the island's energy production, significantly worsened the situation.
Cyprus is not a regular on international bond markets, but at current yields it has been effectively shut out of that financing option. Until now it met its borrowing needs from domestic markets.
Last week, central bank governor Athanasios Orphanides warned it could be forced to seek a bailout unless tougher austerity measures were taken immediately .
Moody's also cut its growth outlook for Cyprus, to zero this year and to 1 percent in 2012, due in part to reduced power production after the Vassilikos explosion.
Downward ratings pressure could also be exerted if problems in the Cypriot banking sector - holding between 4.5 and 5 billion euros of Greek debt - were to require a substantial injection of government money, Moody's said.
It last downgraded Cyprus in February, when it cited the same structural and Greece-related concerns. Rival agencies Fitch and Standard and Poor's, which have also downgraded Cyprus this year, both rate the country at A-.
Moody's said it would consider a rating upgrade if Cyprus introduced sweeping structural reforms in its social transfers system and public sector wage bill, and recorded significant and lasting cost savings.
Vassilikos was destroyed when a cargo of confiscated Iranian munitions stored in a military base several hundred metres away from the plant exploded.
Since then, Cyprus's state-owned electricity authority, which has an effective monopoly on power generation, has introduced rolling power cuts. Economists have estimated the cost of the blast and its consequences at at least 1 billion euros, a significant slice of Cyprus's 17.4 billion euro economy.
Cyprus launched a plan on July 1 to cut spending in the civil service and scrap a number of state-owned organisations. But that programme and anticipated further measures to deal with the fallout from the blast face significant political hurdles.
On Tuesday, a number of parties accused the government of backtracking on reforms because they feared an angry backlash from Cyprus's powerful labour unions.
The two parties in Cyprus's centre-left government do not have an absolute majority in parliament to push reforms through so any measures have to be adopted by consensus.
Moody's said that if any of the plans were watered down or delayed significantly that could prompt a further downgrade. An increasingly fractious political climate added to implementation risks, it said.
"There are so far no short-term measures to compensate for the plant's destruction," Carlson said. "We think this will mute the government's planned range of structural measures that have been designed to improve fiscal sustainability over the medium term."
(Editing by John Stonestreet)