NICOSIA Tiny Cyprus may become the next trouble spot in the euro zone's debt crisis, as credit rating agencies downgrade it because of exposure to Greece and rising yields suggest investor demand for its bonds is shrinking.
Cyprus does not face any near-term funding problem, and by many fiscal measures it is much healthier than Greece, Ireland and Portugal, which are receiving international bailouts.
But after a 0.8 percentage point jump in Cypriot government bond yields during May, some analysts think the country might conceivably have to seek a bailout in the long term.
"There is an increasing risk that Cyprus might join the GIP (Greece, Ireland and Portugal). It is not necessary, but many indications point toward Cyprus getting closer to asking for external help," said David Schnautz, an interest rate strategist at Commerzbank in London.
A Commerzbank research report last week recommended that investors refrain from buying Cypriot government bonds. "My view is that many investors look at Cyprus as being very, very close to Greece, and if they don't touch Greece anymore they won't touch Cyprus either," Schnautz said.
A euro-denominated Cypriot 10-year government bond issued to international investors in February 2010 was bid at 7.01 percent on Thursday, up from around 6.20 percent in mid-May and 4.20 percent in the middle of last year.
During the crises in Greece, Ireland and Portugal, investors viewed the 7 percent level as a danger signal for 10-year bond yields, believing governments might be unable to afford to fund themselves over the long term at such an expensive level.
Cyprus accounts for only about 0.2 percent of the 17-nation euro zone's economy and has gross financing needs of roughly 2 billion euros this year, which is tiny compared to the 110 billion euro size of Greece's three-year bailout program.
So the European Union could easily afford any rescue of Cyprus. However, a fourth bailout in the euro zone could unsettle markets by underlining the way in which the debt crisis can spread as problems in one country affect other states.
With its banks sitting on an estimated 5 billion euros in Greek sovereign debt and its economy heavily exposed to Greece through trade, Cyprus has been downgraded by all three major credit rating agencies over the past several months as the Greek crisis has worsened.
At the end of May, Fitch Ratings cut Cyprus by three notches to A- with a negative outlook because of the risk of a Greek debt structuring that might force the Cypriot government to spend money on recapitalizing local banks.
Cypriot banks have taken steps to boost their capital in the past year and Fitch said they were "relatively well placed" to withstand even a 50 percent cut in the principal of Greek bonds.
It estimated the cost of recapitalizing the banks to a Tier 1 ratio of 10 percent under that scenario would be 2 billion euros or 11 percent of gross domestic product.
Cyprus would actually be in better shape than many other euro zone countries to shoulder such a burden. Its debt to GDP ratio is projected by the EU at 62.3 percent this year, lower than the weighted average for the zone; Greece's ratio is 157.7 percent and Ireland's, 112.0 percent.
Its projected budget deficit this year is 5.1 percent, well below Greece's 9.5 percent and Ireland's 10.5 percent.
But another issue is also worrying investors: the Cypriot government's delay in cutting back high expenditure on a bloated civil service and addressing pension reform. The public payroll accounts for 30 percent of annual budget spending, and if steps are not taken, it could hit 50 percent in coming years, central bank governor Athanasios Orphanides told parliament last year.
"It's easy to say the markets and rating agencies are jittery right now, but something must be done to address concerns," said Michalis Florentiades, head of economic research at Hellenic Bank.
The Communist-led government has been tussling with a now opposition-led parliament for more than a year on how to bring down the budget deficit, and had a proposal to raise corporate tax blocked last year.
As a government rooted in labor movement activism, it has proceeded cautiously in cutting the civil service. There has been a chill in relations with Orphanides, whose frequent references to reform irked Communist President Demetris Christofias to the point where he said the central banker was talking too much.
The Finance Ministry says the significance of the rise in secondary market bond yields should not be overestimated. A report by the Public Debt Management Office in March described it as an illiquid market with no primary dealers, where a lack of volume data hindered an objective assessment.
This week the government showed it could raise money comfortably in the domestic market; it issued its first 10-year bond for domestic investors since 2007 with an average yield of 6.252 percent. Including a five-year issue, it sold a total of 79 million euros of debt.
"Traditionally Cyprus has been able to shun international markets in favor of domestic," said economist Fiona Mullen. "The local banks were always very liquid; they have only gone to international markets to get a benchmark in the past."
Between 2004 and 2007, when Cyprus was running similar deficits to today, it borrowed more than 7 billion euros from local banks in short-term Treasury bills. It did not tap the international market between 2004 and 2009.
But staying out of the international market for too long would be risky for Cyprus; it could lose touch with foreign investors, making it more difficult to raise money from them if banking or economic problems required the government to raise more money than expected.
Authorities say that "subject to market conditions," they aim to issue a bond to international investors, but when this would happen is unclear. It is also considering private placements.
"We will need to go to international markets at some point, so now is the time to send a message that we are serious about addressing our problems," said Michael Sarris, a former finance minister.
(Editing by Andrew Torchia)