Ratings agency Moody's on Wednesday downgraded its Cyprus government bond rating by two notches to Baa1 from A2, citing the eurozone member's weakening medium-term credit fundamentals and a blast which took out its main power station.
"The outlook is now negative," Moody's said, adding that it had also reduced its forecasts for Cyprus's economic growth to 0 percent in 2011 and one percent in 2012.
The ratings agency said in a statement one of the key driver's for the downgrade was ongoing concern about Cyprus's fiscal position, amplified by the fiscal fallout from the massive explosion on July 11 of munitions stored at a naval base which killed 13 people and took out the Vasilikos power plant.
Moody's also cited the "increasingly fractious domestic political climate, which has increased implementation risks to the government's new fiscal plans."
It warned further that there was a material risk that at least some Cypriot banks will require state support over the medium term as a result of their exposure to Greece.
"The negative outlook reflects Moody's view that, in the current environment, the risks to the Baa1 rating are skewed to the downside," it said.
While the government had recently announced a range of structural measures intended to improve fiscal sustainability, "the positive impact of those measures for the next few years will be reduced by the (power) plant's destruction," Moody's said.
"This incident has caused material disruption to the Cypriot medium-term economic and fiscal position."
The Cyprus government was plunged into a political crisis after the blast, with the defence and foreign ministers already having resigned and the junior government partner considering pulling out altogether.
"The second driver of the downgrade is the increasingly fractious political climate in Cyprus in the wake of the plant's destruction," Moody's said.
"This adverse development increases implementation risk to the government's plans, many of which will require not just cross-party support, but also acceptance by the trade unions," it said.
It also warned that the Cypriot government may need to extend capital support to at least some of its banks over the next few years given the "substantial exposure of Cypriot banks to a sovereign default and macroeconomic stress in Greece."
"Overall, just under 40 percent of the total loans extended by the three largest domestic Cypriot banks are to customers based in Greece," it said.
Central bank governor Athanasios Orphanides last week warned that Cyprus could be headed for a bailout in the wake of the blast.
In a letter sent to Cypriot President Demetris Christofias, Orphanides warned that the Cyprus economy "is in a state of emergency."
"To avoid the worst, including admission into a support mechanism, further and more drastic measures must be taken immediately," Orphanides said.