An imbroglio in Cyprus

England takes on San Marino tonight in the archetypal "David v Goliath" football fixture. The result is all but inevitable - the microstate has won just a single victory in its entire history.

But the outcome of a struggle between one of Europe's economic minnows and the continent's behemoths is far less certain. At the time of writing, Cyprus was just "hours away" from a deal that will save it from armageddon, according to wire reports. Seasoned watchers of the sovereign crisis will know that EU governments have a tendency to let deadlines, however vague, slip.

Nonetheless, we are likely to receive news either this evening or over the weekend that will shape market direction next week and possibly well beyond. Cyprus constitutes just 0.2% of the eurozone's GDP but the mishandling of the bailout means that its influence outweighs its economic clout. First, the Cypriot parliament rejected the initial plan agreed with the EU; namely, a levy of 6.75% on depositors with less than €100,000, rising to 9.9% on deposits over €100,000.

Since then, a hodgepodge of proposals have emanated from Cyprus and been swiftly rejected by the EU. Russia, which has considerable deposits in Cypriot banks, has also been approached for help. The request was apparently dismissed out-of-hand - perhaps Russia was still smarting from the deposit levy suggested initially?

If so, it may come to regret its lack of consideration. The latest news indicates that 'Plan A' is back on the table, but with some important modifications. Depositors with less than €100,000 will no longer be hit by the levy, so sums above this amount will be hit by a considerably higher rate than 9.9%. The could be in the region of 15%, though it is difficult to say without knowing if one of or more of any of the Cypriot banks will have some of their assets put into a 'bad bank'. Cyprus may well have decided that it has little chance of saving its offshore financial industry, giving it little incentive to kowtow to Russia

Unfortunately, in the days that it took Cyprus to reach this decision - if indeed it has - irreparable damage has been done to the country's financial system and its economy. The banks may reopen on Tuesday if a deal is struck. However, they will probably feel like they are closed due to the capital controls being planned. Deposit flight is inevitable with or without a deal, hence the need for capital controls.

What if a deal isn't agreed? The ECB has said that Emergency Liquidity Assistance (ELA), currently being administered to the two largest Cypriot banks, will be suspended on Monday if a bailout isn't in place. If the threat is carried out, Cyprus's financial system will surely collapse and the country will be sliding on steep slope out of the eurozone.

The prospect of a country exiting the euro doesn't seem to bother the broader markets. The Markit iTraxx Europe index S19 closed the week at 118.5bps, 0.5bps tighter than Thursday's level. When the effects of Wednesday's roll are taken into account, this is only a few basis points wider over the week.

Perhaps the markets are very confident that a deal will be agreed. Or it could be that investors don't believe that the ECB would follow through on its promise to turn the life support machine off. After all, Mario Draghi has said that he will do "whatever it takes' to preserve the euro. It could come down to whether he is ready to risk the central bank's credibility and extend liquidity to insolvent institutions, against an even worse scenario of Cyprus leaving the euro with all the contagion that implies.

We will have a better idea next week if Cyprus really does pose a systemic risk. But the debacle has exposed the inherent flaws in the structure of the eurozone that still haven't been fixed. This won't help business confidence, and leading indicators show that the European economy is likely to shrink again this quarter. The contrast with the US is stark - Markit PMIs this week highlighted the growing dichotomy. European credit has underperformed its North American counterpart this year, and the Cyprus imbroglio has only made matters worse.

Download full article