The Cypriot government has been dissolved by President Demetris Christofias precisely at a moment when the financial markets are questioning the country's creditworthiness. Some of the nasty symptoms preceding the Greek, Irish and Portuguese bailouts are rearing their heads in Cyprus.
One of the notable benchmarks is the cost of insurance against default.
As could be expected Cypriot banks are exposed to Greek debt. One bank – Marfin-- held €3.4 billion in Greek bonds and 46% of its outstanding loans are to Greek customers. Moody's Investor Services has just downgraded the bank to quasi junk status. Only slightly better off is the Bank of Cyprus holding €2.4 billion in Greek bonds.
The exposure of the Cypriot banks is significant because the banking system is inordinately larger than GDP. Russians extracting capital from their country have used Cyprus to get into the EU banking system. If they were to pull their money out this could create severe problems. Cyprus is running a substantial deficit both in terms of the budget and in current accounts.
Given the power of the unions the country's ability to make the necessary economies is questionable.
If these problems were not enough, Cyprus is expected to lose $1 billion this year because of a huge explosion at a naval base. An Iranian ship carrying munitions to Syria was seized and the munitions were stored at the base under conditions that were not secure (they were left to bake in the sun). In the explosion 13 people were killed including the commander of the Cypriot Navy.
The blast also destroyed a nearby power plant that supplied half the island's electricity and will take a year to fix. This has caused power shortages throughout the island. The island is still divided into Greek and Turkish parts as the Greek Cypriots did not live up to a gentleman's agreement with the EU to regularize the situation after they were accepted for membership in the EU.
Cyprus when compared to Italy and Spain is a relative minnow. Fixing the debt crisis in Cyprus will not break the European Bank.
However, economics is also a question of psychology. Another European debt crisis will further erode the already depleted confidence and strain the generosity of the donor countries.