Why Cyprus Matters

European officials have impressed upon investors that the tail risks of a EMU break up have receded markedly. Some officials talk even that the crisis is over. The premium that Italy and, to a less extent, Spain, pay over Germany has narrowed to levels previously thought possible only if the ECB were to make good on its promise of unlimited (ex ante) purchases. There have been some signs that foreign investors are participating in the primary and secondary sovereign European bond market. Ireland is returning to the capital markets.

To be sure, challenges remain. Greece's will and ability to impose more austerity is questioned. Spain has relied on cuts in public investment over the last several years while other spending has actually risen. With higher issuance this year than last, apparently without the help of another LTRO (with some borrowing, perhaps around 100 bln euros expected to be paid back early -- beginning as soon as the end of Jan), Spain's funding challenges are likely to resurface. Italy's elections next month could still result in a hung parliament, with Monti's centrist movement seemingly contributing to the fragmentation.

Size Doesn't Matter
However, it is Cyprus that may be the most pressing issue. Yes it is small and few international investors have any exposure. Its significance extends beyond its size.

Four main Issues
First, the amount of assistance it needs is still not determined and won't be until later this month. Nor, contrary to reports, will the Europe be a in position at the finance ministers' meeting in early Feb. to devise an aid package. That will forces the Cyprus government to rely on "creative" fund raising, such as "borrowing" the money from state-owned institutions and pensions. Aid now seems unlikely until March at the earliest.
Second, reports (in the German media) at the end of last year warned that Cyprus banks have been used to avoid taxes and launder (primarily Russian) money. Which has prompted concern from the German SPD and Greens. German Chancellor Merkel has had to rely on support from these opposition parties for her European agenda. Aid to Cyprus could be rejected by the German Bundestag, which would raise broader concerns.German elections are likely in September and the SPD's Steinbrueck's campaign is not off to an auspicious start. However, this issue could become a wedge. Moreover, Lower Saxony holds state elections in a couple of weeks and it could see Merkel's ally -- the FDP -- further implode along with a shake up in the party's leadership. The CDU is polling near 40% and will likely need an ally to form the new government.

Third, while the Troika (EU, ECB, IMF) had looked like a solid front in the early stages of the European crisis, fissures appeared toward the end of 2012. These fissures are evident in dealing with Cyprus. The IMF wants the private sector to participate in burden sharing (i.e., debt restructuring/haircut) before tax-payer money is brought to bear. Yet previously, European officials indicated that Greece was unique in requiring a debt restructuring. Although at first European officials resisted the IMF's participation, it now seems they are reluctant to proceed without it.

Finally, the EU has been accused of playing political favorites. For example, some reports suggest that EU officials were aware of at least some of the deception of the conservative Greek government before 2009, but was reluctant to confront it for fear of bolstering the opposition Socialists. Now it appears European officials want to distance themselves from Cyprus Communist president, Christofias. Merkel, for example, who will visit Cyprus later this week, is not expected to meet him. Cyprus will hold presidential elections on Feb. 17. If no candidate receives 50% of the vote -- the most likely scenario given recent polls -- a second round will be held on Feb. 24.

Exit Risk Remains
While we argued, last year, against the widespread view of a Greek exit, we are not as sanguine about Cyprus. Although one does not see it reflected in the survey or policy markets like intrade.com, we suspect the risks of a Cyprus exit are greater than currently appreciated.