A flap over a potential bailout for Cyprus is heightening anxieties that its economy could become the next flash point in the eurozone's debt crisis.
A rescue programme for Cyprus will require substantially reducing government and bank debt, Olli Rehn, the European Union's economics commissioner, said in a recognition that a more conventional bailout of the latest eurozone country to hit financial difficulties would leave it with too much debt. The rescue will also require a major restructuring of the country's banking system that may lead some banks to be wound down or merged, Mr Rehn said.
Charles Dallara, managing director of the Institute of International Finance, said Cyprus had the potential to spark another phase of the eurozone crisis. He said the "bailing-in" of uninsured depositors would set a precedent that would have an effect elsewhere, for example in Spain. "I don't see the key players coming together to find solutions here. It may be small, but it is a eurozone member and it has the potential to generate stress and contagion throughout the eurozone", he said
The banking system must be overhauled, as in Spain, Mr Rehn said. "There is going to be very substantial restructuring and even if necessary winding down of banks and merging of banks", which took a bad financial hit from Greece's debt restructurings last year, he said.
Cutting debt means the eurozone and IMF would lend Cyprus substantially less than the estimated €17 billion European officials previously said would be needed to right the government finances and stabilise the banks, which were hurt by Greece's debt restructurings last year. Cypriot banks had invested heavily in Greek government bonds as well as loans to Greek households and companies. The eurozone has discussed using its bailout fund directly to boost the capital of struggling banks, so that governments don't have to take on debt to do it. But, under current plans hashed out by eurozone finance minister late last year, that is unlikely to happen until 2014 at the earliest. Mr Rehn said under plans now being worked on, governments would have to contribute something to such bailouts to retain some "skin in the game".
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