Small Cyprus May Trigger Big Trouble in Europe

Nicosia, Cyprus
Staton R. Winter | Bloomberg | Getty Images
Nicosia, Cyprus

Cyprus may seem too small for markets to care. But UBS has warned that the Mediterranean island is big enough to cause trouble in the euro zone after seeking a bailout from the troika, made up of the International Monetary Fund, the European Commission and the European Central Bank.

After all, this is not the first time a relatively small economy has threatened to trigger a pan-European domino effect ranging from Ireland, to Greece and Portugal.

"The Cypriot case has all the ingredients to raise questions about the consistency of the euro project again, comparable to -albeit possibly less dangerous than - the Grexit hysteria less than a year ago," said economist Martin Lueck from UBS.

The country desperately needs 17.5 billion euros in bailout funding to recapitalize its troubled banks and pay its bills on time after taking a hit from its large exposure to the Greek economy. In the meantime, Cyprus became overly dependent on Russian money after asking for a 2.5 billion euro loan granted by the Russian government at an interest rate of 4.5 percent in December 2011, sparking allegations of money laundering by oil oligarchs in Cypriot banks.

So far, it seems that the Troika bailout won't come easily as European authorities have already voiced their concerns over money laundering and tax evasion in the island. European Commissioner for Economic and Monetary Affairs Olli Rehn told the Cypriot authorities that it must take a strong stance against money laundering if it wants aid. Cyprus has denied the allegations and seems reluctant to accept the conditionality attached to the bailout package. The Euro group is set to meet on Jan. 21 but a solution to the Cypriot dilemma is only likely to come after the country's presidential elections on Feb. 17.

"Being too harsh on Cyprus in terms of conditionality would increase the risk of even more Russian influence," said Lueck. "But, being too soft could risk allegations of sacrificing core EU taxpayers' money to bail out deposits of Russian oligarchs."

And so it seems that Europe is once again stuck in a nerve-racking exercise of political brinkmanship that could end the euphoria over the Draghi plan that has seen Spanish 10-year bond yields fall below 5 percent.

"If this proves correct, it would likely mean that peripheral spreads would widen and risk assets could turn more volatile, especially in view of Italy's election and Spain's funding needs,"added Lueck from UBS.

Cyprus lost access to market funding in April 2011. It is rated CCC by S&P, B3 by Moody's and BB- by Fitch.