by Ashley Kindergan  The Financialist

The next few months will be critical for high-stakes negotiations underway in Cyprus, where exposure to the Greek financial crisis and domestic economic troubles have left the government teetering on the brink of default and banks running dangerously short of capital.

The latest euro-zone economy to negotiate a European Union-International Monetary Fund bailout package is also one of its smallest. Cyprus, a country of about 1.1 million people, has been said to need an approximately €17 billion bail-out ($23 billion) nearly equal to the size of its economy in order to recapitalize ailing banks and keep the government running until 2016. Negotiations have been going on since June, and Credit Suisse European analyst Yiagos Alexopoulos said he expects a deal to be finalized in May.

“The problems in Cyprus are driven primarily from the financial sector and, in that respect, it’s more similar to the source of the problems that we experienced in Ireland,” said Credit Suisse Europe analyst Yiagos Alexopoulos. “It’s for sure a difficult situation right now, given the circumstances.”

Cyprus has a €1.5 billion loan coming due in June and has gone without access to bond markets for two years. The country averted a default late last year by borrowing against the pension funds of state-owned companies.

Recent elections stand to change the tone of the discussions with Europe and the IMF going forward.  Alexopoulos said that an electoral victory for center-right candidate Nicos Anastasiades, who has good relationships with European officials and supports the four-year fiscal reform program agreed upon with the EU, European Commission and IMF, would be  a stabilizing influence on the country. In national elections on Sunday, Anastasiades won a first-round presidential vote but failed to grasp an absolute majority although he is widely expected to win the second round of voting.

“It’s very likely that the negotiations will restart on a better footing than before,” Alexopoulos said. “There have been a lot of negative statements from European politicians – not very strong statements, but still – expressing their irritation with the lack of progress in the negotiations over the course of the last six months.”

Both European officials and Cypriot politicians have said publicly that they are not considering a strategy similar to that used in Greece, in which private investors and depositors in Cypriot banks would be forced to take losses on sovereign debt write-downs. Ironically, the Greek haircuts contributed to the troubles of Cypriot banks. Loans that Cypriot banks made to Greek residents that went sour during the crisis, alongside the domestic slowdown and local property bubble, also played a role in the current crisis, Alexopoulos said.

Cypriot banks need €10 billion to be adequately recapitalized, according to market estimates reported in the press, though a definitive review of the banks’ funding needs is not yet complete. But Alexopoulos pointed out that Cyprus’ official sector and ailing local banks own most of the government’s outstanding debt, and imposing losses would make the financial system’s troubles even worse.

“In forcing losses on this debt, you’d basically have to recapitalize the banks, and the benefit would be very small,” he said. “I think it would create more problems than it would solve.”

Among those problems is the chance that a so-called bail-in, which has been seen as a one-time-only tactic to rescue Greece, could raise concerns in the market for other European peripheral countries.  Moody’s has said that adopting the tactic in Cyprus would have negative credit implications for all European banks.

At the same time, a coalition of European finance ministers has said outright that they are trying to keep Cyprus’ bail-out, the sixth euro-zone intervention since 2009, as small as possible.

“We are trying to lower the amount which would be brought together by the member states,” Euro-group President Jeroen Dijsselbloem said last week.

Privatizing state-owned enterprises and selling assets could be a way to bring Cyprus’ total debt levels down, Alexopoulos said.

Cyprus faces an austerity package that Alexopoulos has estimated will result in fiscal tightening worth 3 percent of GDP this year, raising questions about how the tiny country will be able to get back to economic health. But there are reasons to be hopeful that Cyprus will not face a Greek-style cycle of austerity-related stagnation.

First, Alexopoulos said, the fiscal tightening contemplated in Cyprus is much less than that imposed in Greece, as is the country’s debt burden, which could rise as high as 140 percent of GDP. By comparison, Alexopoulos wrote recently, European authorities and the IMF consider Greece’s debt level sustainable at 160 percent of GDP. In addition, the Cypriot economy is more open than the Greek one, which should ease the pain of the austerity measures. Natural resource discoveries also open up hope for future growth.

“Let’s not forget that Cyprus recently found natural gas reserves on its coast,” he said. “One thing about a relatively small economy:  Small things can make a much bigger difference. So, if there are investment inflows that have to do with the natural gas reserves exploitation, it can have a significant impact on the whole economic growth of the country.”

The role that Russia, a country with major economic ties to Cyprus, would play in a rescue also remains unclear. The Euro-group is insisting on checking the books of Cypriot banks for any potential improprieties before agreeing to a bail-out. There has also been widespread speculation about Russian money allegedly being laundered through Cypriot banks.

“We know that there are many account holders with a foreign background (in Cyprus), and part of those are undoubtedly Russian,” Dutch Finance Minister Dijsselbloem said recently. “That plays a role.”

Alexopoulos said he expects Russia to roll over a loan it has already made to Cyprus when it comes due in 2016, perhaps on more favorable terms.

No one knows yet exactly how Cyprus’ future will unfold, but one thing is certain − the small country will receive an outsize amount of attention this spring.

“The next two or three months will be critical,” Alexopoulos said.

For more on this story go to:

http://www.thefinancialist.com/eu-bail-out-focus-turns-to-cyprus/