Moody's said in a statement Wednesday that it has placed Cyprus' rating on review for further possible downgrade.
It says that a Greek euro exit would likely raise the amount of money that the government may need to support its heavily Greece-exposed banking sector.
The agency said the two-notch downgrade also reflects the fact that the Cyprus' finances are already strained and that it can't borrow from international markets.
The downgrade comes as an added blow to the eurozone country as it seeks €1.8 billion ($2.6 billion) to help recapitalize its second-largest lender, Cyprus Popular Bank, which is most heavily exposed to Greek debt.
Cyprus' finance minister suggested on Wednesday that the government could seek a European Union bailout to support the bank before crucial elections in Greece this Sunday which are seen as a vote on whether the country stays or leaves the eurozone. Vassos Shiarly said a loan from another country was also an option.
Greece is holding the June 17 repeat election following an inconclusive May 6 ballot in which voters turned to smaller, mainly anti-bailout groups that have promised to renege on Greece's austerity commitments that were made in exchange for international bailout money.
Moody's said it now believes that Cyprus will need more money to support its banks than its earlier estimate, equivalent to 5-10 per cent of the country's gross domestic product. It said recapitalization costs would now increase the country's debt levels by just over 10 per cent of GDP.
The agency said these increased risks for Cypriot banks "may lead to much larger recapitalization costs to the government, and Moody's needs to reflect these in the Cypriot sovereign's ratings."
On Tuesday, Moody's downgraded two of Cyprus' top three commercial banks by a notch over the heightened risk that Greece may leave the eurozone.
Moody's said its review of Cyprus will focus mainly on political developments in Greece and how these could heighten the risk for Cypriot banks. It will also take into account Cypriot government plans to seek EU support for its banks and what strings may come attached.
Shiarly said earlier this week that he's optimistic Cyprus won't be forced into enacting harsh austerity measures if it seeks an EU bailout because of its low fiscal deficit and public debt relative to other EU members.
Cyprus has vowed to stick to a 2012 deficit target of 2.5 per cent of gross domestic product and is preparing additional spending cuts and tax rises to fix a 1 per cent deviation.
More importantly, the country wants to be seen by its EU partners as living up to its promises in the hope of clinching favourable terms on a possible EU bailout, such as protecting its low 10 per cent corporate tax — a key selling point for its large services sector.
Standard & Poor's agency currently rates Cyprus at BB+, a notch below the junk threshold, while Fitch rates the country at BBB, or a notch above junk.Suggest a correction