How Cyprus could become Europe’s biggest headache

Remember last summer in the eurozone?

It was chaos. Investors were pulling cash out of Europe's banks; Italian and Spanish yields were spiking; emergency meetings of European leaders were taking place every other day. Some sort of crack-up seemed inevitable.

Then Mario Draghi, the head of the European Central Bank (ECB), uttered his three magic words: "whatever it takes".

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Investors believed him. The promise of unlimited intervention to keep Spain, Italy and other high-debt countries afloat calmed markets. In short, there would be no repeat of Greece, where many private lenders to the country ended up getting back just cents on the euro.

Bond yields fell. The exodus of money stopped. In fact, Dutch bank ING now thinks that, since September, nearly €100bn has come back into the peripheral countries.

And because Draghi didn't need to print a ton of money in the end, the euro has gone up. It's now near a 14-month high against the dollar.

But the problem with promises is that you may end up having to stand by them. And now one tiny eurozone country could see Draghi's best-laid plans unravel.

Cyprus

Cyprus is Greece (but with even dodgier banks)

You might think that with all the woes afflicting the euro area such as recent revelations over Spanish corruption, and the return of Italy's Silvio Berlusconi - Cyprus would be the last of its worries.

This tiny nation joined the European Union less than eight years ago. It accounts for just 0.2% of the eurozone's GDP. How can it be important?

Here's why. The one key thing pinning the eurozone together at the moment is Mario Draghi's credibility. Cyprus could stretch that credibility to breaking point. It's a vital test of whether the ECB means what it says.

Like the other peripheral' economies, Cyprus has high levels of state debt and a collapsing economy. As a result, it has been shut out of the bond markets for over two years, and so cannot refinance its debts in other words, it can't renew its existing loans.

But with the economy expected to shrink by 3.5% this year, it won't be able to repay its loans either. A large number are due to mature in the next three years, starting with €1.5bn in June.

On its own, this isn't a big problem. Indeed, last year the Troika (the eurozone bail-out committee) agreed to give Cyprus a €7bn loan that would allow it to meet its debt obligations.

However, this loan was dependent on Cyprus bailing out its banking system. Unfortunately, Cyprus is a bit like Iceland or Ireland (or the UK for that matter) in that its banking system is far larger than the underlying economy. Indeed, it's about eight times the size.

This means that Cyprus needs a total of €17bn in support.

This might not be a problem either, in itself. The trouble is that Cyprus has a fairly shady reputation as being a haven for crooks looking to hide their ill-gotten gains. While this may be unfair, up to a third of deposits come from Russia.

Because of this, the idea of recapitalising the banks with European money- effectively a bail-out for criminals - is very unpopular in Germany. And Germany has the power to veto the second part of the loan and therefore the whole package.

TheECB has been applying a lot of pressure, arguing that if Cyprus is allowed to go bust, there could be large knock-on effects. For instance, the two largest Cypriot banks control a sizable share of the Greek banking market.

And there are signs that German leader Angela Merkel may have accepted its arguments in private. However, she still has to sell it to the German people and with an election this year, the opposition are not going to do her any favours.

Could a bail-out even work?

However, even if Germany allows the loans to go through, the problems don't end there.

Fiona Mullen of Sapienta Economics estimates that, with the full loan, Cyprus' state debt will hit 136% of GDP by 2016. This is clearly unsustainable, and far more than the International Monetary Fund (which forms part of the Troika) is prepared to allow. She thinks that Cyprus will need to find at least €3bn in savings.

In theory, there are many ways that these savings could be found. For instance, Cyprus could sell the rights to gas fields and state assets. Alexander Apostolides of the European University, Cyprus thinks that size of the bank bailout could also be reduced. But these would only be partial solutions.

If an agreement can't be reached, then the only real option left that would put Cypriot debt on a sound footing, is for private holders of government debt to take a haircut'. In other words, to be repaid less than the face value of the bond. This is usually in the form of a lower interest rate or a longer term. Indeed, the Cypriot finance minister has explicitly talked about this possibility.

Since Cypriot banks hold a large amount of Cyprus' debt, most of the pain will have to be pushed onto foreign bondholders. This is exactly what happened to Greece, and it's exactly what investors had hoped the ECB would never allow to happen again.

So if holders of Cypriot debt do take a haircut, it will damage the credibility of Draghi's promise to holders of Spanish and Italian debt. In turn, they will start to pull out of European debt markets again, leading to capital flight and higher yields once again.

The ECB will then be forced to choose between printing money or letting some of the weaker countries leave. While either solution will be good for output in the euro area (a weaker currency would boost exports across the region), they will both hit the value of the euro.

There are several ways to protect your portfolio from this. One option is to buy gold. However, my colleague John Stepek has a look at the one currency which should do best out of the coming crisis here: How to avoid a pounding in the currency wars.