Cyprus on financial brink from Greek exposure

NICOSIA (Reuters) - Cyprus is racing to meet an end-June deadline to pump 1.8 billion euros ($2.24 billion) into Cyprus Popular Bank - heavily exposed to Greek bonds - but will struggle to attract investors as long as the outcome of this month's election in Greece is unclear.

The island nation's only other option is finding the money - about 10 percent of its economy - itself, raising the odds that it will become the fourth euro zone country to be bailed out after Ireland, Portugal and Greece.

It is an increasingly familiar example of how quickly problems at just one bank can hurt government finances - even if in this case, the sector was profitable and well regulated, and had successfully raised capital in the past.

"Cypriot banks were pretty much OK all the way up to 2010. They were quite conservative, never lent more than their deposits and never invested in toxic assets. Then they lent money to the Greek government, and those assets became toxic," said Fiona Mullen, an economist at Sapienta Economics.

With the Greek election on June 17 hanging in the balance, and scenarios mounting about the possible exit of Greece from the euro zone, bankers say that this is discouraging potential investors in Popular.

"That is the single most important factor that is keeping people, strategic investors, funds and others, from investing in the Group," Michael Sarris, Popular Bank's non-executive chairman, told Reuters in an interview.

"They (investors) are comfortable in helping cover the existing capital requirements, but they are not comfortable at the idea that it may end up being a lot more."

Cyprus, most of whose population is Greek Cypriot, has close cultural, business and political links with Greece, but that relationship has not been without difficulties as Greece's economy has crumbled.

Once a linchpin of growth in Cyprus, Popular's capital shortfall is a predicament for the euro zone's third-smallest economy, which has been shut out of capital markets for a year, hurt by its heavy reliance on Greece's troubled economy.

Small wonder then that Nicosia is considering all its options - including some creative ones.

Popular has floated the idea of bundling its Greek assets under one of its Greek subsidiaries, which could make it eligible to take part in the recapitalization planned under that country's financial rescue by international parties.

"We have to sever the Greek operations of the Cypriot banks. The Cypriot banking system has a gangrene. You have to sever the part that is dangerous and grow it again," said economist Stelios Platis, who has his own consultancy.

DARING PLAN

Popular, the country's second-largest lender, was hit by a 76 percent writedown on its holdings of Greek sovereign bonds in its 2011 results, with an impairment loss of 2.3 billion euros, depleting its capital buffers.

The European Banking Authority (EBA) told it to replenish its coffers with an extra 1.97 billion euros, and Popular must meet this requirement by June 30. So far it still faces a shortfall of 1.8 billion euros.

If it needs extra equity, Nicosia has pledged to take up any shares that are left over by investors.

In return, it would give the bank zero-coupon government bonds, which the lender could then use as collateral to secure loans from the European Central Bank.

Spain recently launched a similarly daring plan for Bankia, the stricken lender which has asked for a hefty 19 billion euro extra cash. But it is not clear whether the ECB and other European authorities will approve such constructions.

And with yields on its debt trading at a prohibitively expensive level above 13 percent, Cyprus has few options other than seeking external aid if Europe rejects the plan.

"Entering a bailout with the EU appears inevitable," said Symeon Matsis, an independent economist.

There is one escape route from such an embarrassing move. Cyprus received a 2.5 billion euro bilateral loan from Russia last year and is in talks with another country - rumored to be China - to come to its rescue.

Cyprus has traditionally had strong ties with Moscow, with many Russians holding cash on the island. So far, the numbers show that foreigners aren't worried.

Central Bank data for April show a 0.5 percent year-on-year increase in total deposits in Cyprus to 71.6 billion euros. Of that figure, there was a 29 percent increase in deposits by other euro zone residents.

Of the Cypriot banks, Popular is the most heavily exposed to Greek government debt, though the island's largest lender, Bank of Cyprus used to hold a hefty slice of Greek sovereign debt too, totaling 2.0 billion.

But Bank of Cyprus has whittled down its own capital shortfall of 1.57 billion euros to just 200 million euros, and plans to sell two insurance divisions to bridge the rest.

Hellenic seems to be escaping relatively unscathed, holding only 100 million euros in Greek sovereign debt, which it has already written down.

But economists fret that damage from Greek government debt may be the tip of the iceberg, as Cypriot banks also have up to 23 billion euros of loans outstanding to companies and individuals in Greece.

(Editing by Douwe Miedema and Giles Elgood)

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