Europe Economy

Cyprus Jitters: How It Could Still Go Wrong

Trader on the floor of the NYSE
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Although markets initially held up in the face of renewed chaos, market watchers and analysts are warning that the flare up in the euro zone debt crisis could once again curb investor sentiment.

Cyprus agreed to a bailout early Monday morning on the conditions that Cyprus' second largest lender, the Popular Bank of Cyprus, would be wound down and a levy imposed on uninsured deposits over 100,000 euros ($130,000) in the country's banks.

Investor sentiment may be holding firm on Tuesday after a negative finish at the close on Monday, but fears continue to surround the struggling island nation.

"We would not rule out that a larger than previously anticipated relief, starting with an even more substantial haircut of uninsured deposits, might be needed," Daniele Antonucci, an economist at Morgan Stanley said in a research note.

(Read More: New EU Law Could Include Tax on Uninsured Deposits)

"In the near term, we are concerned that a Greek-style recession, as a result of the end of Cyprus' economic model – a good part of which was based on a certain kind of banking – might produce a still unstable debt trajectory."

Markets are more resilient than during Greece's debt-crisis, the bank conceded, and Cyprus looks less systematic than its neighbor, it said.

But a "taboo" has now been broken according to Morgan Stanley, which is concerned that a precedent has now been set.

(Read More: Big Cypriot Bank Depositors Could Lose 40%: Minister)

"We regard this as a potential policy mistake, as the risk is that depositors in the weak parts of the euro zone might hypothetically draw parallels with the Cypriot situation in a bear case scenario. This is because there's now more than one 'unique' country with 'unique' problems addressed in a 'unique' way," it said.

Meanwhile, Fitch put Cyprus on rating watch negative, saying the shock from the country's banking system could damage the domestic economy and thus public finances. The agency currently rates Cyprus B, a speculative rating.

Comments from Jeroen Dijsselbloem, head of the Eurogroup, could be a sign of things to come. Market jitters spread on Monday as he told reporters that the rescue plan for Cyprus could serve as a model for dealing with future banking crises in the euro zone.

Despite backtracking on his comments he has received strong criticism as analysts dissect his words. The European Commission said on Tuesday that large depositors could be bailed in in future bank rescues, prompting a selloff in banking stocks.

(Read More: Cyprus Orders All Banks to Remain Closed Until Thursday)

"The comments from Eurogroup president and Dutch finance minister Dijsselbloem undermined the euro yesterday, as his indication that Cyprus is a 'template' for the rest of the euro zone created general fears about the safety of the European banking system, in spite of subsequent backtracking," the research team at Lloyds bank said in a note.

Marshall Gittler, head of global FX strategy said it was as if Dijsselbloem had "dropped a bomb" and savers across Europe would now worry for their deposits.

"Given the lack of confidence in bank stress tests for gauging the safety of individual banks, savers are likely not only to move their money into the stronger countries (i.e. Germany) but also outside the euro zone entirely," he said in a morning note.

Financial stocks were the hardest hit on Monday after a volatile few days of trading and Gittler said that it was significant that it was French banks that led the move lower.

(Read More: Cyprus Bailout a 'Gift' to US Banks: Bove)

"France is teetering between a core and a troubled peripheral country; if it slips into the latter category, then the troubled euro zone countries will outweigh the core and the euro will be doomed," he said.

Bill Blain, senior fixed income broker at Mint Partners, feared the current state of Europe's banks after recent revelations saying that Monday's comments from Dijsselbloem probably creates the worst capital funding environment since 2008.

"Let's just assume Europe's banks go back to square one," he said in a research note.

By's Matt Clinch