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Crisis in tiny Cyprus creates big mess for Europe

For such a tiny country, Cyprus and its failing banks have created an awfully big economic, financial and geopolitical mess for European bankers and government officials.

The island nation – with land mass and economy smaller than Vermont – was bracing Sunday for the looming collapse of its banking system and economy, as scores of officials from Brussels to Nicosia spent the weekend scrambling to avert the crisis.

Cypriot President Nicos Anastasiades, en route to the European capital of Brussels on Sunday, has "a very difficult task to accomplish to save the Cypriot economy and avert a disorderly default," a government spokesman said.

That task grew more difficult by the hour.

Europe’s so-called "troika" – its central bank; its political body, the European Union; and the International Monetary Fund – were holding firm to a joint ultimatum to accept their latest bailout offer by Monday. If the Cypriot parliament won't go along, the country faces an immediate cutoff of a financial lifeline that has kept Cyprus’ bloated banks – a lucrative tax haven for wealthy Russian depositors – afloat for months.

The latest gambit, a 20 percent tax on bank accounts bigger than the $130,000 insured limit, has yet to win approval from the Cypriot parliament. The plan would also intensify the ongoing political backlash from wealthy Russian depositors, along with local account holders still seething with resentment over Europe’s insistence that any bailout inflict direct financial hardship on the Cypriot people.

So far, there appears to be little immediate risk of the crisis spreading to the global economy or financial market, according to most analysts.

"The market doesn't care,” said Carnegie Mellon economist Adam Lerrick. “Cyprus is a tiny economy. Its banks are not highly connected with the rest of the international financial system. There is no risk of contagion here."

But even if a deal can be struck to fill in a $7.5 billion hole in the Cypriot banking system, the standoff between Nicosia and Brussels has inflicted lasting damage on the island nation’s economy, opened up new rifts between Russia and Europe and widened the political divide pitting the eurozone’s wealthy northern countries against its struggling southern neighbors.

“What could go wrong here?” wondered Carl Weinberg, chief economist at High Frequency Economics. “Just about everything.”

For starters, a $7.5 billion bailout would amount to a band-aid for Cyprus' bloated banks. Swollen by more than $30 billion in Russian deposits, they've recently held up to 10 times the nation’s annual economic output. Much of the rest consists of bad bets on Greek bonds recently subject to a European-imposed "haircut."

Even with a proposed restriction on withdrawals, those banks now face a tidal wave of withdrawals and losses when they reopen after a week-long, government-imposed “holiday.”

The bailout also would do little to rescue the indebted Cypriot government.

“After the banking system is stabilized – a technocratic matter – the government itself is out of cash and has no access to the financial market,” said Weinberg. “The terms for fixing the government, unlike the stark choices for resolving busted banks, are still wide open to negotiation.”

The crisis has left European leaders with even bigger problems.

The plan to force bank depositors to pay for their own bailout, a so-called “bail-in,” hasn't gone unnoticed in other heavily indebted countries with weak banking systems. Now, millions of deposits in other southern European countries with much bigger economies, like Portugal, Spain and Italy, are left to wonder just whether their banks accounts may be the next to be raided.

“This is the first time that a government has ever reneged on the 100,000 euro guaranteed deposit scheme," said Wilbur Ross, an American investors who specializes in turning around failed companies. "That's a little bit scary because there's no bank in the whole world that can withstand a real run.”

Europe’s weaker banks can ill-afford to see depositors grow more nervous. In Spain, for example, cash has been flying out the door since last summer, when the government took over four banks sinking under the weight of bad mortgages and stuffed their bad assets into a new entity called Sareb. With house prices – and the overall Spanish economy - still shrinking, state-owned banks continue to post massive losses, adding to the Spanish government’s debt.

Failure to strike a bailout deal with Cyprus also would rattle more than just a Spanish bankers nerves.

By turning its back one of its member states, European central bankers would renege on a pledge to do “whatever it takes” to keep the common currency intact. The likely departure of Cyprus from the euro would increase the odds that voters in Spain, Italy, Greece or Ireland, chafing under northern Europe’s demands for economic sacrifice, might also decide to go it alone.

“The whole condition of the euro has been that once you go in you cannot get out,” said Julian Callow, Barclays chief international economist. “Now, if a country does leave for whatever reason, that sets a really important precedent. People start asking questions in other countries as well.”

Resentment has been simmering for two years in countries with weaker southern economies looking to their northern neighbors for help. While voters in Germany grow weary of subsidizing ongoing bailouts, many in the southern tier believe that the wealthier northern companies are profiting from their economic pain.

“Despite the very peculiar rhetoric that German voters hear from some of their politicians, they have benefited handsomely from this crisis,” said Athanasios Orphanides, the former Cyprus central bank governor who oversaw its entry to the euro. “The German government is essentially getting money at zero interest rates in the credit markets, and then it's loaning it to Ireland at very high interest rates. And of course, the money goes back to the German citizens.”

Despite the widespread political and financial risks, European officials and central bankers appear steadfast in holding Cyprus to the onerous terms that have produced ongoing street protests as one failed plan yielded to another.

Some analysts believe that resolve has been fortified by long-running frustration with Cypriot bankers’ refusal to rein in risky deposits, based in part on the assumption that Europe would have to bail them out if they got into trouble. Ongoing tensions between Europe and Russia on a range of issues - including Cyprus’ recently-discovered, sizable natural gas deposits – have further complicated matters.

But in the end, Europe may pay a heavy price if it refuses what amounts to about $23 in aid for every Cypriot citizen, according to Weinberg.

“That is less than a night at the movies with a family or cafe lattes and croissants for two at Starbucks,” he said. “This is the cost of ensuring that the public sees no bank in Euroland will be allowed to fail and that they can take out their deposits. Is this so much to pay?”