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European officials have impressed upon investors that the tail risks of an EMU break up have receded markedly. Some officials talk even that the crisis is over. The premium Italy, and to a less extent Spain, pays over Germany has narrowed to levels that were previously thought possible only if the ECB were to make good on its promise of unlimited (ex ante) purchases. There have been some signs that foreign investors are participating in the primary and secondary sovereign European bond market. Ireland is returning to the capital markets.

To be sure, challenges remain. Greece's will and ability to impose more austerity is questioned. Spain has relied on cuts in public investment over the last several years while other spending has actually risen. With higher issuance this year than last, apparently without the help of another LTRO (with some borrowing, perhaps around 100 bln euros expected to be paid back early - beginning as soon as the end of January), Spain's funding challenges are likely to resurface. Italy's elections next month could still result in a hung parliament, with Monti's centrist movement seemingly contributing to the fragmentation.

However, it is Cyprus that may be the most pressing issue. Yes it is small and few international investors have any exposure. Its significance extends beyond its size.

There are four main issues. First, the amount of assistance it needs is still not determined and won't be until later this month. Nor, contrary to reports will the Europe be a in position at the finance ministers' meeting in early February to devise an aid package. This will force the Cyprus government to rely on "creative" fund raising, such as "borrowing" the money from state-owned institutions and pensions. Aid now seems unlikely until March at the earliest.

Second, reports (in the German media) at the end of last year warned that Cyprus banks have been used to avoid taxes and launder (primarily Russian) money. This has prompted concern from the German SPD and Greens. German Chancellor Merkel has had to rely on support from these opposition parties for her European agenda. Aid to Cyprus could be rejected by the German Bundestag, which would raise broader concerns.

German elections are likely in September and the SPD's Steinbrueck's campaign is not off to an auspicious start. However, this issue could become a wedge. Moreover, Lower Saxony holds state elections in a couple of weeks and it could see Merkel's ally the FDP further implode and cause a shake up in the party's leadership. The CDU is polling near 40% and will likely need an ally to form the new government.

Third, while the Troika (EU, ECB, IMF) had looked like a solid front in the early stages of the European crisis, fissures appeared toward the end of 2012. These fissures are evident in dealing with Cyprus. The IMF wants the private sector participate in burden sharing (i.e., debt restructuring/haircut) before tax payers' money is brought to bear. Yet, previously, European officials indicated that Greece was unique in requiring a debt restructuring. Although at first European officials resisted the IMF's participation, now it seems that they are reluctant to proceed without it.

Fourth, the EU has been accused of playing political favorites. For example, some reports suggest that EU officials were aware of at least some of the deception of the conservative Greek government before 2009, but was reluctant to confront it for fear of bolstering the opposition Socialists. Now it appears European officials want to distance themselves from the Communist president of Cyprus, Christofias. Merkel, for example, who will visit Cyprus later this week, is not expected to meet him. Cyprus will hold presidential elections on February 17. If no candidate receives 50% of the vote, which is the most likely scenario given the recent polls, a second round would be held on February 24.

While last year we argued against the widespread view of a Greek exit, we are not as sanguine about Cyprus. Although one does not see it reflected in the survey or policy markets like intrade.com, we suspect the risks of a Cyprus exit are greater than currently appreciated.

Source: Why Cyprus Is Important