Cyprus appeared to win conditional support for its bailout bid from EU paymaster Germany on Friday, hours after a savage credit ratings cut intensified the indebted island's economic misery.
Rating agency Moody's slashed Cyprus by three notches to Caa3 late on Wednesday, taking it further into "junk" territory, and warned it could be downgraded again.
It predicted the country's debt pile would continue to rise because of the capital needs of its banks, burned by their exposure to crisis-wrecked Greece, and said it saw an even chance of default..
Germany, wary at the prospect of bailing out a country it says must improve financial transparency, nonetheless said European Union members must stand by each other.
"Cyprus must move forward with its own obligations and reforms to the economy but at the same time we must show solidarity," Ms. Merkel told reporters as she arrived in Cyprus for talks with other conservative politicians. She said that was a fundamental EU principle.
Cyprus, one of the bloc's smallest economies, applied for a financial rescue last June after its banks suffered huge losses on the EU-approved writedown on Greece's debt, and is expected to be the fourth recipient of a euro zone bailout.
"The challenges are really huge, but I am sure if and when the country can get a new and strong and committed leadership capable of strengthening confidence ... it will have a tremendous positive impact," Finnish Prime Minister Jyrki Katainen said on Friday.
The comments were a boost for Cypriot opposition leader Nicos Anastasiades, who is a frontrunner to win parliamentary elections on February 17.
Mr. Anastasiades, who leads the right-wing Democratic Rally party, was hosting a meeting on the island of the European People's Party, an EU-wide group.
He told Reuters on Thursday he was committed to meeting the terms of any international aid package.
A potential rescue bill of €17-billion, roughly equivalent to its entire economic output, has deepened concerns among EU partners about Cyprus's debts, and some doubt it would be able to repay the aid without more concessions from lenders.
Germany has expressed unease about channelling taxpayers' money into a country seen by some as a hub for money laundering. Cyprus, a popular tax haven for wealthy Russians, says it fully complies with international rules against money laundering.
Debt restructuring has been ruled out as an option by both Nicosia and Brussels, with European Economic and Monetary Affairs Commissioner Olli Rehn quoted as saying on Friday that a 'haircut' was not under consideration.
Reacting on Friday to the Moody's downgrade, Cypriot Finance Minister Vassos Shiarly said he wanted to focus on the positive, saying he looked forward to the conclusion of a bailout deal.
"A conclusion on a memorandum of understanding does improve the prospects," he told state radio. Asked about the rating action, he said: "We are not at all happy about it."
Cyprus's outgoing leftist government has faced criticism that it was slow to adopt financial reforms, and to negotiate effectively with lenders. It has been relying on short-term, high-yield borrowing from domestic banks and public corporations for the past several months.
Cyprus is expecting the results of an asset review of its banking sector on January 18. Preliminary reports suggest banks will need anything between 7.3 billion and 10 billion euros.
Under the worst-case scenario, an assessment Cypriot authorities are hoping to avoid, the total bill for a bailout could rise to €17-billion. With fiscal needs, that would push Cyprus's eventual debt burden to 140 per cent of GDP.
Economists say a debt restructuring would be futile in Cyprus's case as the majority of its debt is held by the domestic banks a bailout would be aimed at saving.
"It might satisfy someone's sense of justice, but it wont solve the problem," said Nicosia-based independent economist Fiona Mullen. "There aren't any easy answers out there, apart from giving them a thousand years to pay it back."