NICOSIA (Reuters) - Cyprus may soon have to seek an international bailout, becoming the fourth state in the euro zone to request a rescue if it does not take urgent action to repair its finances, the island's largest commercial bank warned on Monday.
"With our inaction we are risking the ability of refinancing the state and the consequences will be immediate and serious," Bank of Cyprus said in a statement.
"There is an imminent threat of Cyprus joining the European Union support mechanism, with whatever drawbacks that will entail."
Since the euro zone's sovereign debt crisis erupted last year, the EU and the International Monetary Fund have announced multi-year bailouts of Greece, Ireland and Portugal totalling 382 billion euros (336.1 billion pounds).
A rescue of Cyprus, which accounts for only about 0.2 percent of the 17-nation euro zone's economy and earlier this year was expected to have gross financing needs of roughly 2 billion euros for 2011, would not strain Europe's resources.
But it would be an unwelcome reminder of how the region's debt crisis can spread as problems in one country affect other states. All three major credit rating agencies have downgraded Cyprus in the last several months because its banks are sitting on an estimated 5 billion euros in Greek sovereign debt and its economy is heavily exposed to Greece through trade.
On Friday, Standard & Poor's downgraded the island again by one notch to BBB+ and warned that another cut was possible, citing the government's inconsistent commitments to spending cuts as well as exposure to Greece.
Talks on spending cuts were left in disarray last week, as opposition parties accused the government of backtracking on reform pledges and the cabinet tendered its resignation in response to public anger over a munitions blast that destroyed the island's biggest power station, causing an energy crisis.
The European Commission said in a statement on Monday that a financial assistance programme for Cyprus was not being discussed, adding: "We are confident the Cypriot authorities will fulfil their commitments" to cut the budget deficit.
The island's Finance Ministry said Cyprus had no significant funding needs until mid-December and would continue efforts to find additional financing, domestically and internationally, for requirements after then.
In the wake of the destruction of the power station, Cyprus may receive EU funds for infrastructure development, which could reduce pressure on it to seek a financial bailout. Also, the government has traditionally been able to rely on cash-rich local banks to buy much of its debt.
Nevertheless, soaring bond yields on Monday showed some investors were speculating about the possibility of severe financial trouble. A euro-denominated Cypriot 10-year government bond issued to international investors in February 2010 was bid at 10.54 percent on Monday, up from 9.71 percent on Friday and around 6.20 percent in mid-May.
Central bank governor Athanasios Orphanides warned authorities two weeks ago that a bailout was likely without immediate action to correct fiscal imbalances.
Bank of Cyprus said any bailout would damage the island's reputation as a financial services centre. Cyprus offers a series of tax breaks to international businesses, and might not be able to continue providing all of them under the terms of an international rescue.
The island received more bad news on Monday when data showed the central government budget deficit widened sharply in the first half of this year to 3.47 percent of gross domestic product on a cash basis, from 1.87 percent a year ago. Revenue fell 1.42 percent while expenditure was 9.15 percent higher.
Authorities have said they are aiming for a general government budget deficit, which also includes accounts for local governments and some semi-governmental corporations, of 4.0 percent of GDP or less for 2011, after a 2010 shortfall of 5.3 percent.
But that forecast was made before the July 11 munitions blast slapped the state with a bill which, according to opposition parties, could reach 3 billion euros. Preliminary finance ministry assessments have slashed the island's growth outlook this year to zero from expansion of 1.5 percent.
Analysts believe Cyprus cannot continue financing itself over the long term if it has to return to the market at current yields. Credit default swaps for Cyprus, used to insure against the threat of a sovereign default, hit a record high of 707 basis points on Monday, more than triple their January level and closing in on levels near 1,000 bps for the euro zone's weakest states, according to data monitor Markit.
Writing by Andrew Torchia; Editing by John Stonestreet