Around four dollars in every ten of deposits in Bermuda's banks are held by non-residents — and any sudden withdrawal of a large proportion of that money would put pressure on the Island's balance of payments and its fixed exchange rate with the US dollar.

That is the view of Standard & Poor's Rating Services analyst Nikola Swann, whose analysis of the Island's economy resulted in S&P lowering Bermuda's credit rating outlook to negative from stable.

The agency affirmed the Island's long-term sovereign credit rating at AA, but revised the outlook to negative, meaning S&P may lower the rating during the next six months to two years.

The report cited risks stemming from the Island's banking sector as the main reason for its action and also noted that government debt levels were set to rise "noticeably" over the next two years — although they would remain a low level compared to other countries it rates.

In response to questions from this newspaper, Mr. Swann, S&P's associate director, Public Finance and Sovereign Ratings, explained some of the banking-related risks he had identified.

"Bermuda's banks pose risks to the government's fiscal position inasmuch as the Government may feel the need to incur debt (or spend assets) of its own to recapitalise one or more of them," Mr. Swann said.

"The guarantee the government has already extended to purchase Butterfield Bank preferred shares, if needed, to complete the bank's $200 million capital raising efforts, is a classic example."

The banks posed risk to the Island's external position — that is, what Bermudians owe to non-residents versus what non-residents owe to Bermudians — he added.

"The banks' assets and liabilities are so large, relative to the domestic economy, that a large and sudden shift in deposits held by non-residents (which we estimate at roughly 40 percent of deposits at Bermudian banks) could significantly impact Bermuda's balance of payments, potentially disrupting the fixed exchange rate and imposing costs on any attempt by Bermudian authorities to maintain it (in such a scenario, there would also be costs to abandoning it), were the banks to have problems in providing the desired external liquidity from their own external assets," Mr. Swann said.

"The relatively high ratings we have on the two major banks (AA- on Bank of Bermuda; A- on Butterfield Bank) mean that we still view such a scenario as unlikely, but the negative outlook on the former rating, and watch developing on the second, together with recent developments at these banks, and a more risky global operating environment for banks in general, mean that the risk of such a scenario appears to be rising."

In its report, S&P estimated Bermuda's banks had external assets at 251 percent of Bermuda's gross domestic product and external debt of 127 percent, as at the end of 2008.

The government's increasing level of debt was less of a concern to S&P, because the Island continues to have one of the lowest rates of indebtedness of all rated countries.

The agency expects general Government deficits to rise from three percent of GDP in 2008 to five percent this year.

Mr. Swann said that some additional public spending during the global economic downturn was understandable and useful. But his concern about the debt would be much greater if the trend of "fiscal deterioration" were to continue long after recovery was apparent.

"The noticeable increase in government deficits which we expect, and the resultant rise in net general government debt (small net creditor to small net debtor), both represent some fiscal deterioration, but are smaller concerns in the developing context of Bermuda's overall sovereign credit profile," Mr. Swann said.

"Some degree of counter-cyclical fiscal policy, particularly in the current recessionary global environment, is both understandable and useful.

"Moreover, Bermuda's substantial public pension fund assets provide a significant fiscal cushion, helping Bermuda's net general government debt position to remain quite strong compared to most rated sovereigns, even with this deterioration.

"The sustainability of Bermudian fiscal policy would be more of a concern were such trajectories to continue well beyond the point when economic growth has begun to recover, as this would no longer represent a cyclical phenomenon."

S&P's sovereign ratings, which range from C (lowest) to AAA (highest), assess the probability that a country will default on its debts. Any downgrade would make it more expensive for the Government to borrow money.