Europe, Cyprus Locked in a Multi-Billion-Dollar Game of Chicken

Simon Dawson | Bloomberg | Getty Images

With European central bankers locked in a multi-billion-dollar game of chicken with the tiny island nation of Cyprus, the global financial markets Friday were watching closely to see which side blinked first.

Both sides, though, appear to be stubbornly holding firm.

Faced with the threat of a cutoff Monday of European support for its insolvent banking system, the Cypriot parliament was considering a series of last-ditch measures to head off a looming economic and financial collapse.

"The next few hours will determine the future of the country," government spokesman Christos Stylianides said before Friday's session.

The proposals, which amount to Plan C, include seizing state-sponsored pension funds, putting up state assets that include rich natural gas deposits, and splitting the country's second-largest bank into a "good bank" and "bad bank," which would hold the riskiest assets.

The stakes for Cyprus are bigger than the loss of tens of billions of bank deposits that have bled from its banking system over the past few months, according to central bank governor Panicos Demetriades. He warned political leaders Thursday that unless the measures are approved, Cyprus second largest bank faces a disorderly bankruptcy when it opens on Tuesday after a weeklong "holiday."

Plan A was shot down by the parliament Tuesday, after depositors woke up Monday to news of the nasty surprise terms of the latest bailout.

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In exchange for another backstop, Europe's central bankers proposed a so-called "bail in" in which some of the cost would be paid locally by Cypriot depositors. The raid on deposits would clip between 6.75 and 10 percent of Cypriot people's savings, raising a $7.5 billion down payment against $12.9 billion in rescue loans.

Faced with overwhelming political backlash to the plan, Cypriot officials on Thursday looked sought an emergency backstop from Russia, a major the source of Cypriot bank deposits.

Thanks to a favorable tax deal signed in 1998, Cypriot banks are bulging with deposits from Russian companies and investors, whose cash has swollen the assets of the nation's banks to more than six times the size of its economy.

But on Friday, Cypriot finance minister Michalis Sarris, returned home empty handed.

(Read More: Cyprus Leaves Russia Empty-Handed)

As the clock ticks down, the Cypriot economy is slowly starving for cash. Though cash machines remain open, one of the countries two large banks has imposed limits on how much depositors can withdraw. Many shops and gas stations are refusing to accept credit cards.

Workers at Laiki, the nation's second largest bank, gated to protest the restructuring plan that would likely cost many of them their jobs.

But things haven't worked out the way European bankers had hoped, according to Simon Maughan, a financial sector strategist at Olivetree Financial Group.

"The Cypriots said 'Well, great. Now we've got this huge banking system. Now we've got the guarantee from the Europeans. We'll just keep carrying on as we were," he said. "It's been a massive multi-year political standoff. And the only way to deal with that is to bust the banks."

The rejection of the initial plan to tax bank deposits touched off a stand-off between Cyprus and European officials, who are showing no signs of budging on their efforts to rein in Cypriot banks – even if it sends the local economy into downward spiral.

That could trigger the country's departure from the common currency, with potential fallout in much larger economies of Italy, Spain a Portugal.

(Read More: Are Markets Too Complacent Over Cyprus?)

"Cyprus is playing with fire," Volker Kauder, a leading conservative ally of German Chancellor Angela Merkel, told public television ARD.

The prospects for the latest, last-ditch solutions remain uncertain. Even if the Cypriot parliament approves the politically painful measures now on the table, there's no guarantee they'll go far enough to satisfy that European officials.

Merkel reportedly told German lawmakers Friday that the plan to nationalize Cypriot pension funds was unacceptable, and that there would be no bailout with a major overhaul of Cypriot banks.

"There is no way we can accept that", she reportedly told lawmakers. "I hope it does not come to a crash."