FOREX-Euro undermined by concerns Cyprus woes may escalate
* Euro weak near 3-month low vs dollar on Cyprus problems
* Nicosia "unlikely" to endorse bailout deal - govt spokesman
* Soft German ZEW could be fresh blow to euro
LONDON, March 19 (Reuters) - The euro fell on Tuesday as Cyprus's parliament was set to reject a controversial bank deposit levy crucial for the country to secure financial aid but which has raised fears of fresh euro zone instability.
These concerns could prompt long-term investors to sell the euro, traders said. And if the ZEW German investor and analyst survey at 1000 GMT showed sentiment was hit in March due to uncertainty stemming from an inconclusive Italian election, the common currency could quickly drop below $1.29.
The euro was down 0.25 percent from late U.S. levels at $1.2921, but holding above a three-month low of $1.2882 hit on Monday, after a Cyprus government spokesman said a plan to levy taxes on bank deposits was unlikely to be approved by parliament. That would push the island closer to a default and a banking collapse that could have repercussions across the euro zone.
Rejection of the deposit tax plan would inject fresh volatility in to financial markets and weigh on the euro. Safe-haven German bund futures were higher while European stocks fell in opening deals as did bond prices of heavily-indebted countries like Spain and Italy.
"If the vote doesn't go through, it would lead to another precipitous fall in the euro as worries about a banking crisis will escalate," said Adam Myers, European head of FX strategy at Credit Agricole, who expects the euro to drop to $1.27 in coming months.
He said the euro was unlikely to gain much support from the German ZEW survey, given attention was focused on Cyprus.
Against sterling, which is often bought as a shelter in times of heightened uncertainty in the euro zone, the euro wallowed near a five-week low of 85.34 pence hit on Monday to change hands at 85.66 on Tuesday.
"If the plan is voted down, there will surely be fresh selling in the euro," said Tohru Sasaki, the head of Japan rates and FX research at JPMorgan Chase Bank.
The common currency faces an uphill battle to close the yawning gap to Friday's close of $1.3076, although analysts saw support at its 200-day moving average of $1.2875.
Sasaki said the euro looked vulnerable as its rebound from Monday's three-month low was much smaller than its bounce after the fall triggered by a Greek election last May, when investors were shocked by the ruling coalition failing to win a majority.
"On Monday after the Greek election, the euro almost fully recovered from a 1 percent loss in Asia. But that turned out to be a high for many months to come, as the euro kept falling in the next two months and a half," he said.
Analysts said the unprecedented plan to impose taxes on citizens' savings would unnerve savers in larger European countries and could prompt them to withdraw funds.
As a result, the more liquid dollar and the Japanese yen, often sought during times of financial instability and economic stress. would remain in vogue.
The dollar index, which measures the greenback against a basket of currencies, was up 0.1 percent at 82.759.
The dollar was up 0.2 percent on the day at 95.35 yen with the Japanese currency likely to be driven by any comments from incoming governor of the Bank of Japan Haruhiko Kuroda, who assumes the post on Wednesday.
Expectations are huge for Kuroda to put in place an aggressive monetary policy which will help lift Japan out of deflation and which is likely to weaken the yen.
"If the dollar-yen manages to break above the top of its 93-96 yen range then it could sail pretty easily to 98," said Michiyoshi Kato, senior vice president of forex sales at Mizuho Corporate Bank. "Of course, if Cyprus blows up, risk sentiment would spike, meaning it might be difficult for it to get there."