INSIGHT-Desperate for bailout, Cyprus plays risky geopolitical game

* Cyprus faces stark choice between Europe and Russia

* Gas exploration already fuelling wider regional tensions

* At worst, outcome for Europe and island bleak

By Peter Apps and Henning Gloystein

LONDON, March 21 As it tries to play Russia off against Europe to salvage its economy, Cyprus has embarked on a high-stakes poker game that could see almost everyone lose.

Its banks shattered by exposure to Greek debt, the island state urgently needs a way of bailing out its financial system.

Cypriot policymakers hope they can begin to monetize as yet undeveloped offshore gas fields and position themselves as a vital source of energy for Europe.

However, such income is still years away and delusions of becoming the Qatar of the eastern Mediterranean in the 2020s may prompt Cyprus to overplay its hand now.

In the coming days, Nicosia may have to choose between a European bailout that punishes savers - including both ordinary Cypriots and much richer Russian investors - and a deal with Moscow with as yet unknown strings attached.

At worst, it could emerge with its financial system - by far the biggest contributor to the economy - in ruins along with relations with its closest allies.

"Cyprus has always been complicated," said James Ker-Lindsay, a senior fellow at the London School of Economics and expert on the 50-year-old conflict between Greek and Turkish Cypriots. "But this is by far the most complex it has been.

"They are in trouble. They may not want to make these decisions, they know they have to."

The implications go well beyond Cyprus. Images of shuttered banks and lines at cashpoints could spark bank runs elsewhere in Europe, endangering the stability of the single currency.

In the background, a long-simmering conflict between the Greek Cypriots in the south and the Turkish Cypriots in the north of the divided island worries the rest of the region.

Greek Cypriot officials hoped speeding up gas exploration would help them out of a financial hole. But in doing so, they have raised tensions with the Turkish Cypriots who want a joint approach and a share of the revenue.

Turks and Greeks, Israelis and their neighbors are all discovering potential reserves along their disputed borders.

In Washington and Brussels, there are fears that increasing strains between Cyprus and Turkey could lead to confrontation.

"Cyprus may set the tone for the rest of the eastern Mediterranean," says Eric Thompson, director of strategic studies at the Center for Naval Analyses, a U.S. government-funded agency that advises the U.S. military.

"It is where the financial crisis and the gas issues come together. And it is also where they become immediately militarized."

So far, some 200 billion cubic meters of natural gas worth $80 billion at current prices have been discovered in the Aphrodite gas field in Cypriot waters, although the figures still have to be audited.

That would be enough to cover around 40 percent of the European Union's annual gas consumption. Cyprus hopes to start exporting in 2018, but energy analysts say extracting the gas will prove more costly and slower than Nicosia thinks, and Cypriot supplies may run into a global glut, with shale gas plentiful by then in North America, Russia and even Europe.

Successive Cypriot governments have viewed closer ties with Europe as central to their strategy to hold back Turkey and prosper as a bigger regional player.

Working closely with Israel, they aimed to sell eastern Mediterranean gas to a Europe keen to wean itself off dependency on sometimes politically unreliable supplies from Russia.

Cypriot officials say European companies were deliberately prioritized over Asian and other rivals in granting new drilling rights, with the newly elected government of President Nicos Anastiades keen to lean further toward Europe.

That, one official told Reuters last week, could extend to easier access to Cypriot military bases for any European military operations.

Many western states have used the island as a logistics hub to support operations in Iraq and Afghanistan. Former colonial power Britain retains two sovereign bases there but refrained from using them for air strikes on Libya in 2011 out of sensitivity to Cypriot opposition.

The bases are also a listening post for eavesdropping on communications around the Middle East, although intelligence satellites have made such outposts less important.

Until news of Saturday's bailout broke, most Greek Cypriots would have endorsed ever closer European relations.

But with the initial bailout terms - which would have seen even the smallest savers lose more than 6 percent of their deposits - denounced as a little better than robbery, anger at the EU and Germany in particular has soared.

Having committed billions to bailing out other fringe euro zone economies, northern European taxpayers have little appetite for more. That is especially true for Cyprus which Slovak Finance Minister Peter Kazimir told reporters has a business model based on "low taxes, network of lawyers and accountants, as well as hidden 'shadow' companies."

Worried by what it sees as an increasingly assertive Russia, some believe Germany is hoping a bailout will ultimately reduce Moscow's influence on the island and elsewhere in Europe.

If recent days are anything to go by, however, it may have had the opposite effect.

Cyprus is not the first indebted European island to turn to Moscow in hope of help in a financial storm. Iceland did so in 2008 as its currency and banking system imploded, angering allies who saw the NATO member as trying to sell itself out to Russian interests barely a month after the Georgia war.

In the event, Russia did not bite, preferring to leave the struggling country to the International Monetary Fund and European Union. Cyprus, however, has long had closer ties with Moscow based on business interests, a shared antipathy towards Turkey and similar Orthodox Christian faith.

No sooner had news of the bailout terms broken on Saturday than rumors began to circulate suggesting that Russia - and gas giant Gazprom in particular - might offer an alternative deal.

Gazprom denies any such plan. But a host of ideas are now circulating in Moscow and Nicosia, many of them complex and involving gas fields, Cypriot banks and real estate.

Russia could certainly be attracted by access to Cypriot gas, tightening its grip on European supply.

A strategic relationship with Cyprus could make it harder for Western states to use the bases for any military action in Syria, and even offer the Kremlin an alternative Mediterranean port should ally Bashar al-Assad lose his civil war.

Whether such a deal would work as well for Cyprus, however, is another question. Barred from NATO by a Turkish veto, the island was officially "unaligned" during the Cold War but has shown little appetite to be a direct Russian satellite.

A bailout from Moscow might solve the immediate banking crisis but greater Russian sway over Cypriot banks could scare off their Russian clients. Many moved money to Cyprus precisely to avoid unreliable Russian banks, rapacious tax officials and the reach of the Russian state itself.

Fed up with bailing out Mediterranean states and perhaps confident they can ring fence collapse in Cyprus - which makes up less than 0.2 percent of the Eurozone economy - European powers may decide they can afford to let Cyprus fail.

How bad a Cypriot bankruptcy might be for the rest of Europe is, as yet, far from clear.

Earlier this week, one London-based fund described the Cyprus bailout as the euro zone's "Franz Ferdinand moment," comparing it to the assassination of an Austrian archduke in Sarajevo that sparked World War One in 1914.

"That might be an overstatement," said Fiona Hill, a former senior official on the U.S. National Intelligence Council and now head of the Europe Program at the Brookings Institution.

"But it's a very serious situation. You went to bed on Friday night thinking that the Eurozone would survive and woke up on Saturday (after the bailout) wondering how it can." (Additional reporting by Henning Gloystein and Oleg Vukmanovic; Editing by Paul Taylor)