Cyprus may need a bailout to cope with its worst peacetime disaster from a munitions blast unless urgent action is taken to improve the country's finances, Central Bank Governor Athanasios Orphanides has warned.

Already under market pressure because its links to debt-laden Greece, economists have warned the island could face a bill of at least 1 billion euros after the blast a week ago decimated its largest power station, knocking out half of Cyprus's power supply.

Cyprus, one of the euro zone's smallest members, has a GDP of 17.4 billion euros.

Orphanides, a member of the Governing Council of the European Central Bank, said authorities needed to take tougher austerity measures than those under discussion prior to the July 11 blast.

To avoid the worst, including among others admission into (a) support mechanism and all that that entails for the economy and the national issue, further and more drastic measures must be taken immediately, Orphanides said in the July 18 letter sent to Cypriot President Demetris Christofias and copied to political party leaders.

The letter mentioned no specific measures which the central banker wants the government to take.

Orphanides, a former senior adviser for the U.S. Federal Reserve, said he was willing to help in any way possible to overcome the crisis. Relations between him and Christofias are seen as cool at best.

It is the first time Orphanides has suggested Cyprus may need to enter a support mechanism, even though the island's borrowing costs had been rising before the blast. His reference to the national issue was complex reunification talks on the island, ethnically split between Greek and Turkish Cypriots.

The yield on a 10-year government bond issued to international investors in February 2010 was bid at 8.9 percent on Wednesday, up from 8.6 percent a week ago and around 6.20 percent in early May. Cyprus has met its financing needs from the domestic market this year and its secondary market for international debt is very thin.

ECONOMY IN STATE OF EMERGENCY

Weighing up all the facts, the unfavorable international environment, the difficulties in resorting to external borrowing and the additional economic impact from the recent events, I believe that the economy is in a state of emergency, comparable to that of 1974, Orphanides wrote.

He was referring to the Turkish invasion of northern Cyprus in 1974 after a brief Greek-inspired coup. Peace talks are under way to resolve the conflict that is holding up Turkey's admission into the EU. The U.N. wants a deal on the logjam, which will involve concessions from both sides, within the next year.

A copy of the one-page letter obtained by Reuters was forwarded to Christofias before an emergency meeting with party leaders on Monday. The meeting assessed an austerity package already under discussion, and the impact of the blast.

Cyprus has already asked for European Union aid to deal with the aftermath of the explosion, and EU officials have been assessing the damage.

With a budget deficit of 5.1 percent of GDP and overall public debt of around 60 percent, Cyprus is in much better fiscal shape than euro zone bailout recipients Greece, Ireland and Portugal.

But damage from the disaster is still difficult to quantify, other than eliminating growth forecasts for 2011 of 1.5 percent.

Prior to the blast, authorities were discussing an austerity package to cut the number of civil servants, abolish semi-government corporations and introduce small scaled pay cuts in the civil service. Further austerity measures are now under consideration, a finance ministry source said.

The explosion of confiscated Iranian munitions left 13 people dead and triggered rolling power cuts on the island, disrupting business. Vassilikos, the power station destroyed, cost 700 million euros to build.

The munitions, confiscated from a ship sailing from Iran to Syria in 2009 for violating UN sanctions, were stacked in dozens of large shipping containers in scorching temperatures at a military base, despite repeated appeals by army officers for their removal.

Thousands of Cypriots have staged protests demanding the resignation of Christofias, whose foreign and defense ministers quit in the wake of the disaster.

(Editing by Stephen Nisbet)

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