BRUSSELS Just when European leaders thought they were getting to grips with three years of economic turmoil, along came Cyprus, a seemingly small problem but one that cannot be ignored.
While the Cypriot economy may be worth only 18 billion euros, making it the third smallest in the euro zone, the problems it poses are among the most complex Europe has faced, combining elements of Greece, Spain and Ireland.
The latest estimates from analysts are that the country needs 17.5 billion euros to get back on its feet, including 10 billion for its fractured banking sector and up to 7.5 billion for general government operations and debt servicing.
While small in nominal terms, that would amount to almost 100 percent of its gross domestic product, making it the biggest euro zone rescue after Greece and nearly three times the size of the package that was granted to Portugal in 2011.
There's no question that the euro zone has the money to help, the problem is how Cyprus could ever afford to pay the money back - the bailout is just not sustainable. And unless it is made sustainable, the International Monetary Fund will not take part, which would cast doubt on its overall credibility.
"Cyprus is, on a country level, the most serious risk the euro zone faces today," Charles Dallara of the Institute of International Finance, the industry group that negotiated the debt restructuring in Greece last year, said last week.
"I see a disconnect between Cyprus and its euro zone partners, and I see little sense of how to bridge the gap."
DRAWN OUT PROBLEM
In a sense, Cyprus is not a new problem - the country first asked for assistance in June last year and has spent the past seven months in on-off negotiations with the European Commission, the European Central Bank and the IMF on a package.
In the weeks ahead, once elections have been held on February 17 and a new Cypriot president is in place, those talks will come to a head, with the EU and IMF finally certain of who in Cyprus will be responsible for meeting targets in the aid program.
It is possible that the details will be finalized in time for euro zone finance ministers to discuss at the end of March, although some EU officials hint that it could be delayed longer than that, potentially until May.
Despite the delays, the broad components of a package are already in circulation. Cypriot and EU officials indicate that it is likely to require the privatization of state assets - such as the state telecoms firm - major pensions reform, the possibility of a one-off tax on the island's 800,000 citizens and fundamental restructuring of its bloated banking sector.
But even if all of those steps are taken, a big 'if' in itself, they will not generate sufficient extra revenue or savings to cut Cyprus's debts to a sustainable level.
While its debt-to-GDP ratio currently stands at around 80 percent, the net cost of the bailout would push it up to around 140 or 150 percent of GDP, officials in Brussels have estimated, a figure that is decidedly not sustainable.
From the IMF's point of view, it has to be brought below 120 percent, and some officials have said it needs to be closer to 100 percent if it is to be made truly manageable.
That means far more radical steps are required, including the possibility of imposing losses on the Cypriot government's creditors, which EU officials have ruled out, or forcing heavy losses on the country's banking sector.
"That's not an option for us," Olli Rehn, the European commissioner for economic affairs, told Reuters when asked if a sovereign debt writedown was possible, adding: "We are working so that we can reduce the debt burden of Cyprus."
While privatization is the route most often mentioned to generate extra revenue to pay down debt, analysts say there are only three assets worth privatizing: the Cypriot telecoms company, the electricity company and the ports authority, which together would generate a total of 2-3 billion euros.
To go further, and get closer to a sustainable bailout, a restructuring of the country's sovereign debt may be necessary.
Cyprus has only a small amount of sovereign debt, but most of it is held by Cypriot banks, meaning that any writedown would run the risk of exacerbating problems elsewhere in the economy.
"You wouldn't be saving a huge amount of money," said Douglas Renwick, a government debt analyst with Fitch in London, who said 70 percent of the country's debt stock was in the hands of either domestic banks or official sector creditors.
What's more, a big portion of Cypriot debt is issued under English law, which makes any restructuring extremely difficult.
That leaves another, more complicated option - imposing losses on Cyprus's banking sector, which in comparison to the size of the economy is vast, is heavily indebted and heavily dependent on foreign deposits, particularly from Russia.
In a draft memorandum of understanding that outlines the likely terms of aid to Cyprus, the government could be forced to make deep adjustments to its banks, shutting down non-viable operators and potentially imposing losses not just on shareholders but on some bondholders too, officials have said.
"We see it's important that Cyprus and its banking sector will be restructured," Rehn said.
"There'll be some sort of operations as we have seen in Spain of the banking sector with banks winding down, mergers and some recapitalization so that the resilience of the financial sector of Cyprus will be returned, most likely in a much smaller scale than it is today."
Speculation has also covered the possibility of freezing bank deposits over and above 100,000 euros, with that money then held in escrow and used as collateral against debts, but analysts say it would be a risky and wrong-headed approach.
"If they want a bank run or a near complete collapse of the banking system, then go ahead," said one hedge fund manager closely following developments in Cyprus.
The island's banking system, which has assets more than eight times greater than its GDP, holds deposits of around 70 billion euros, with a little less than half that held by non-residents, most believed to be Russian, although the Cypriot central bank does not provide a national breakdown.
Russia, which has longstanding geopolitical ties to Cyprus, has already lent the government 2.5 billion euros over five years and there is the possibility of further loans.
Cypriot President Demetris Chistofias, who was educated in Moscow and who will stand down after the elections, said on Wednesday he had received assurances from Russian President Vladimir Putin that Moscow would take part in international efforts to salvage the island's finances.
Rehn said there had been contacts between the EU and Russia over Cyprus, and he expected Moscow, given its large investments on the island, to make a contribution to any bailout.
"We have had contacts with Russia, but of course they take their own decisions in their own way," he said.
NATURAL GAS REVENUE?
Yet that may make it harder to impose losses on bank depositors, especially non-Cypriot ones. And if at the same time the EU-IMF bailout ultimately protects billions of euros of Russian deposits, it will not go down well with EU taxpayers.
"Giving a bailout to Russian oligarchs is the worst headline you could imagine," said one EU official.
That leaves the euro zone facing a conundrum. Yet there is one element that could prove decisive in the long-run and help square the circle of Cypriot debt sustainability: natural gas.
Cyprus has identified vast reserves of natural gas off its coastline, with estimates of up to 60 trillion cubic feet, with just one block in the Mediterranean basin between Cyprus and Israel estimated to contain gas worth $80 billion.
The gas fields are only likely to come on line in 2018 for domestic consumption and 2019-2020 for export, but that does not prevent the future expected income being securitized.
It is a sensitive issue of national heritage, and it remains unclear precisely how much gas Cyprus will be able to extract and how quickly. But it is a potential escape hatch, and a source of income neither Russia nor the EU would want to ignore.
The immediate problem is that it is politically sensitive, with issues of national patrimony part of the election campaign.
Once the election is over, and a new president is in place, policymakers will apply themselves anew to the puzzle that is Cyprus and see if a solution can be found.
That moment may also be a wake-up call for Cyprus's citizens, giving rise to another potential complication.
"I don't think people in Cyprus have yet realized the extent of the problems," said Alexander Michaelides of the University of Cyprus. "When they do, they are going to be angry."
(Additional reporting by Paul Taylor; editing by Luke Baker and Janet McBride)