The European Bailout That Everyone Forgot About Is Running Into Trouble

After some time out of the limelight, European politicians are bringing contentious bailout negotiations back to center stage in the euro crisis plot line.

In June of last year, Cyprus requested a bailout from the "troika" of eurozone creditors at the European Commission, the European Central Bank, and the International Monetary Fund.

The small eurozone member's outsized banking system was rocked by the Greek bond swap that took place earlier in the year – Cypriot banks were big holders of Greek debt and were forced to take serious writedowns as part of the deal, which necessitated a bailout from the state. This, in turn, forced Cyprus to request aid from the troika.

The deal between Cyprus and the troika still has not been consummated, and today, reports surfaced in the German press that the deal will be postponed until March, and Cypriot banks may require even more cash to be recapitalized than was previously expected. The new estimate is €11 billion, up from €9 billion.

That doesn't sit well with Germany – given the Cypriot banking system's reputation as a "black money" haven for Russian cash – and that means the Cyprus negotiations could become yet another stumbling block for European leaders trying to navigate the ongoing crisis.

A headline in the German newsmagazine Der Spiegel summed up the situation very succinctly in November: "EU Aid for Cyprus A Political Minefield for Merkel."

Today, German leaders on both sides of the parliamentary aisle revealed that there wasn't much support in the German legislature for the Cyprus deal.

"If the impression would persist that the German taxpayer has to be liable for black money in Cyprus, then aid would not be justifiable," Rainer Brüderle, who heads the FDP political party, a junior coalition member in the German government, told the German newspaper Bild.

The opposition said basically the same thing. Sigmar Gabriel, the leader of SDP, told German newspaper Süddeutsche Zeitung, "As things currently stand, I can't imagine German taxpayers bailing out Cypriot banks, whose business model depends on abetting tax fraud."

The November Der Spiegel article mentioned above focused on a classified intelligence report prepared by the German intelligence agency BND on money laundering in Cyprus, and exposed just how pervasive the Russian money laundering through Cyprus had become since the collapse of the Soviet Union.

Der Spiegel also explained German Chancellor Angela Merkel's bind: sign off on a controversial bailout of Cypriot banks funded by German taxpayers, or risk the financial spillovers that could hit the eurozone otherwise.

So, Germany and the troika have demanded of Cyprus the same tough economic reforms and privatizations of state assets that have characterized bailouts of other eurozone member states, like Greece.

However, Cypriot President Demetris Christofias, a communist, has refused to comply with those requests.

This is why reports in the German press today say the negotiations between Cyprus and the troika have been delayed until March – Cyprus holds presidential elections in mid-February, and Christofias is likely to be unseated by a conservative. The troika is hoping he will be a little easier to work with.

Today, in a press conference, Merkel declared, "We agree it is important that the troika should talk with Cyprus and that there can be no special conditions for Cyprus because we have common rules in Europe," and said that "we are far from the end of the talks."

In November, BofA Merrill Lynch FX strategist Athanasios Vamvakidis warned that "Cyprus could prove to be a blind spot that could add to market concerns about the Eurozone crisis."

Although many view Cyprus as a tiny economy without the potential for much spillover, Vamvakidis still provided a few things for investors to think about:

If Cyprus’ debt ends up as high as the above estimates suggest, official sector losses may be difficult to avoid, creating a precedent with implications for other periphery countries. A private-sector debt haircut would have negative market implications for the Eurozone, suggesting that Greece was not a unique case after all and triggering concerns that other countries could follow.

However, beyond such concerns, there is not much private-sector debt to cut. The share of private-sector debt in Cyprus following a program will be very small. Moreover, the bonds under domestic law, which are the ones most likely to be affected by a haircut, amount only to €2.35bn (excluding bonds issued for bank recapitalizations and/or used as collateral for bank ECB borrowing), which is 13.3% of GDP and only 1.1% of the highest estimated debt level under a program.

Any official sector debt relief for Cyprus could lead to similar demands in other periphery countries and strengthen political opposition to the periphery bailouts in the core Eurozone countries.

Concerns that Cyprus, and not Greece, may be the first country to exit the Eurozone could come to the fore. We do not believe that it is in the interest of Cyprus to exit the Eurozone, particularly because of geopolitical concerns and the continued dispute with the occupied territories in Northern Cyprus.

Moreover, Cyprus could in theory default on its official debt and remain in the Eurozone, as its primary deficit is very small. However, markets could become concerned about a Cypriot exit after they realize the risks to the country’s debt dynamics.

In other words, the situation hasn't blown up yet, but it is something to keep an eye on, nonetheless.