(Adds details, background)
CAIRO Dec 21 (Reuters) - Credit rating agency Moody's downgraded Egypt by one notch to B2 from B1 on Wednesday and warned it could cut the rating further, saying the unsettled political situation was undermining investor confidence.
Egyptian officials were not immediately available for comment.
Moody's also cited a deterioration in the country's balance of payments position, exacerbated by falling foreign exchange reserves, which it said raised the risk of a balance of payments crisis if Cairo cannot secure international financial aid.
Government finances are under increasing pressure, raising refinancing risks, the rating agency said.
Moody's said the unsettled political situation was the main driver for the downgrade, citing the installation by the ruling military council of Egypt's fourth government since the popular uprising that toppled Hosni Mubarak broke out in January.
"In Moody's view, the repeated changes in government leadership have resulted in ineffective and unpredictable economic policies," it said in a statement.
"Moreover, the protracted timetable for a transition to constitutional and civilian rule, as demanded by the major political parties, will likely continue to undermine investor confidence in the Egyptian economy." The third round of Egypt's parliamentary election ends on Jan. 11, but it will be followed by a staggered vote for the upper house that ends in March and then a presidential vote in June, after which the army has promised to hand powers to an elected president. Dozens of protesters have died over the last few months in a series of violent clashes with the police and army.
The ratings agency said pressure on Egypt's balance of payments from domestic political turmoil will be further compounded by the economic downturn in Europe, a trading partner and key source of tourism revenues.
In the third quarter of 2011, foreign direct investment fell to $440 million from $1.60 billion a year earlier, helping to create a $2.36 billion deficit in the balance of payments versus a surplus of $14.7 million a year before.
"Moody's believes that the Central Bank of Egypt will find it increasingly difficult to maintain adequate international liquidity in the months or year ahead, raising the risk of a balance-of-payments crisis," the rating agency said.
It said slowing economic growth and lower tax revenues were widening the budget deficit, which it believed would reach 10 percent of gross domestic product in the year to June 30.
Meanwhile, rising domestic interest rates and the short average maturity of Egypt's debt - less than two years, according to Moody's - heightened refinancing risks.
External financial support would relieve pressure on both the budget and the balance of payments, but a meaningful level of such international funding remains elusive.
Egypt's ruling military council in June turned down $3 billion in stand-by loans from the International Monetary Fund because such a deal would infringe on Egypt's sovereignty and burden the country with debt for years to come. The government has not ruled out returning to the IMF if it has to.
Moody's said it would consider a further downgrade if Egypt's foreign reserves continued to decline by the rate of $2 billion in each of the last two months or if its social and political uncertainty continued. (Reporting by Chris Reese and Patrick Werr; Editing by Catherine Evans)