Cyprus Poses Biggest Euro Zone Risk: IIF’s Dallara

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Charles Dallara, managing director of the Institute of International Finance (IIF).

Cyprus, rather than Spain, Italy or Greece, poses the biggest sovereign risk to the euro zone, according to Charles Dallara, the managing director of the Washington-based bank lobby group, the Institute of International Finance (IIF).

"I think Cyprus is, on a country level, the most serious risk the euro zone faces today, not Spain, not Italy, not Greece," Dallara told CNBC in Switzerland on Tuesday.

"I see a disconnect between Cyprus and its euro zone partners, and I see little sense of how to bridge the gap there. This concerns me, and I also think the risk of complacency, of underestimating the potential contagion impact if you mismanage Cyprus, is quite high," he added.

(Read More: As Euro Crisis Fades, Fears of Complacency Emerge)

Cyprus is rated junk or speculative grade by all three major credit ratings agencies, and the country lost access to market funding in April 2011.

The country needs 17.5 billion euros ($23.2 billion) to plug at budget gap and recapitalize its banks, which took huge losses on their exposure to Greek debt. While that might be a small amount in comparison to the likes of Greece, it is hefty given Cyprus's annual gross domestic product of around 18 billion euros.

However, Dallara does not think Cyprus will need a debt restructuring along the lines of Greece's private sector involvement (PSI) deal in March 2012.

"I do not see on the cards a prospect of PSI involvement in Cyprus, because I think it would do little good for Cyprus," he said, adding that Cyprus's debt burden was more manageable than Greece's, because it is predominately held by domestic banks.

Michael Michaelide, rates strategist at the Royal Bank of Scotland (RBS), agreed. "They have high domestic debt ownership, so a PSI would not get you anywhere."

"If there is going to be a PSI in Cyprus, which we absolutely do not expect, you are not going to see Italian bond yields at 4.1 percent and Spanish at 5 percent with a new syndication. You could see a re-escalation of the crisis," he added.

Despite his concerns about Cyprus, Dallara said the euro zone as a whole had "turned a corner" as of mid-2012.

"They have got a long way to go and I would strongly encourage them to moderate, at the margins, the pace of fiscal adjustment, so that we can get these countries' economies growing sooner rather than later."

"But a lot of the other elements that will eventually convince markets the euro zone is going to be okay are going to come into place. It is just going to take time," he said.

- Written by Katy Barnato, reported by Carolin Roth