Fitch Ratings agency on Tuesday downgraded Cyprus' rating by three notches, citing the effects of the debt crisis in neighbouring Greece and warning it could downgrade further.
Fitch said the downgrade of the country's Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) reflected the severity of the Greek crisis.
"The downgrade reflects the severity of the crisis in neighbouring Greece and the risk this poses for the Cypriot banking system and consequently the public finances of Cyprus," said Chris Pryce, director in Fitch's Sovereign Group.
Fitch said the large banking sector of Cyprus, equivalent in terms of assets to approximately nine times its GDP, had become increasingly vulnerable to exposure to Greece since January, when Fitch put Cyprus on Rating Watch Negative.
Roughly one third of the banking system's assets are booked as Greek exposure, including almost 14 billion euros of Greek sovereign bonds and an estimated 500 billion euros of Greek bank bonds.
On Monday, the Cyprus Securities and Exchange Commission had said uncertainty was created in the market by media leaks that Fitch was about to downgrade its ratings and called for the agency to swiftly announce its decision.
Commission chairman Giorgos Charalambous said a speedy declaration by Fitch was needed to safeguard the credibility of the Cyprus Stock Exchange after the market plunged to a 27-month low on Monday.
"We examined the issue and we believe that we must do our utmost to expedite the decision by Fitch to preserve the credibility of the market," he told Cyprus News Agency on Monday, a public holiday in Britain, where Fitch is based, but not in Cyprus.
The CSE on Monday reached its lowest ebb since March 2009 due to jitters caused by the imminent Fitch downgrade and a worsening economic scenario in Greece.
However, in early trading Tuesday it had recovered some ground as the general index edged forward 2.7 percent.
Amid speculation the Fitch downgrade was coming, the government last week declared every confidence in the banking system and its ability to overcome any meltdown in Greece.
Cyprus has received several credit downgrades from international agencies over fears that the banks and the economy are too exposed to toxic Greek debt.
Moody's cut Cyprus's sovereign rating in February to A2, expressing concerns at the exposure of the banks to Greece and structural problems in the island's economy. It has since put the local banking sector on review for an additional downgrade.
Furthermore, Standard and Poor's has cut Cyprus twice since last November based on the same reasoning.
All Cypriot banks passed last year's EU stress test to see if they could withstand a credit crisis.
In April, Cyprus introduced a 0.095 percent levy on financial institutions to fill empty coffers and set aside some cash for a bank support fund.