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Last week Eurogroup head Juncker warned that the situation of tiny Cyprus was more worrisome than Greece. While this seemed to be an exercise in hyperbole, sure enough Monday, a Cyprus official was quoted on the news wires warning of an imminent default.

Hang on. Didn't Cyprus reach a memorandum of understanding with the Troika? Indeed, it did. However, it will take some time to deliver the funds.

Essentially and in principle, there was an agreement on aid in the neighborhood of 17.5 bln euros. This is for the bank recap (roughly 10 bln euros) and for funding the government for three years (7.5 bln euros). An audit of the banks is needed to ascertain their condition and determine the recapitalization needs. PIMCO recently conducted a preliminary audit for the government but the results have not been released. A full audit is expected in mid-January.

As was evident in the recent negotiations with Greece, there are fissures within the Troika. The IMF is reportedly concerned that if Cyprus borrows the funds for the bank recapitalization it could push Cyprus' debt to unsustainable levels. This in turn would prevent the IMF from participating in an aid facility for it.

In the meantime Cyprus has salaries to pay and other obligations. Hence the threat of selective default. Just as officials and traders were winding things down for the year, this seemed to throw a monkey wrench into the budding holiday mood. EMU had survived a challenging year, didn't it?

The threat of default was meant to persuade state-run organizations in Cyprus to loan the government funds for three months as a sort of bridge loan until the aid flows. The government has been locked out of the capital markets for more than a year. It promised to pay back the loan with interest.

The government raised funds from the Cyprus Telecommunications Authority and the Electricity Authority. Reports suggest it was also seeking borrow from the Port Authority. By late Monday, Finance Minister Shiarly claimed the government's short-term financing needs have been met.

This course may be sufficient if the bank audit can be completed in time for the Eurogroup meeting on January 21. Yet Cyprus is a great example of the a banking system that is too big to save. Consider that at the end of last year, the IMF figures suggest Cyprus' bank assets were 152 bln euros, or 8.3x GDP. Assets of commercial banks with Cypriot parents was 92 bl euros or 5x GDP. These Cypriot banks had 29 bln euro exposure to Greece of 1.6x GDP.

The private sector losses in the restructuring of Greece's debt was the prick that popped the bubble. Cypriot banks were forced to seek state aid. The needs overwhelm the government, whose debt is already three-quarters of GDP and rising.

Another complication is that Cyprus goes to the polls in February. The Christofias government lost the confidence of the people. During its five year term unemployment has risen from below 4% to 10%. The debt/GDP ratio has increased by half. The government that the Troika is negotiating is not truly representative of the Cypriot people.

This analysis suggests that although Cyprus has found a way to fund itself for the time being, problems are lurking around the corner and will likely come to a head in Q1 13.

Source: Cyprus: The Dog That Did Not Bite...Yet