FXstreet.com (Barcelona) - Marc Chandler, Global Head of Currency Strategy at Brown Brothers Harriman notes that European investors have impressed upon investors that the tail risks of a EMU break up have receded markedly.

He comments that some officials are even saying that the crisis is over. The premium that Italy, and to a lesser extent Spain is paying over Germany has narrowed to levels that had previously thought impossible only if the ECB were to make good on its promise of unlimited purchases. He sees that there have been some signs that foreign investors are participating in the primary and secondary sovereign European bond market. Also Ireland is returning to the bond market.

He is sure that challenges remain. He writes, “Greece's will and ability to impose more austerity is questioned. Spain has relied on cuts in public investment over the last several years while other spending has actually risen. With high issuance this year than last, apparently without the help of another LTRO (with some borrowing, perhaps around 100 bln euros expected to be paid back early--beginning as soon as the end of Jan), Spain's funding challenges are likely to resurface. Italy's elections next month could still result in a hung parliament, with Monti's centrist movement seemingly contributing to the fragmentation.”

However, he suspects that Cyprus may be the most pressing issue on the table at the moment. Yes, it is small and few institutional investors have any exposure, but its significance extends beyond its size.

Chandler sees four key issues. First, the amount of assistance it needs is still not determined and won´t be until later this month. Nor, contrary to reports will Europe be in a position at the finance minister´s meeting in early February to devise an aid package. This may force the Cypriot government to rely on "creative" fund raising, such as "borrowing" the money from state-owned institutions and pensions. Aid now seems unlikely until March at the earliest.

Secondly, reports in the German media at the end of the last year warned that Cypriot banks have been used to avoid taxed and launder (primarily Russian) money. This has prompted concern from the German SPD and Greens. Chandler comments that Chancellor Merkel has had to rely on the support from opposition parties for her European agenda. Aid to Cyprus could be rejected by the German Bundestag, which would raise broader concerns.

He writes, “German elections are likely in September and the SPD's Steinbrueck's campaign is not off to an auspicious start. However, this issue, could become a wedge. Moreover, Lower Saxony holds state elections in a couple of weeks and it could see Merkel's ally the FDP further implode and a shake up in the party's leadership. The CDU is polling near 40% and will likely need an ally to form the new government.”

Thirdly, while the Troika (EU, ECB & IMF) had looked like a solid front in the early stages of the European crisis, Chandler notes that fissures appeared toward the end of 2012. He writes, “These fissures are evident in dealing with Cyprus. The IMF wants the private sector participate in burden sharing (i.e., debt restructuring/haircut) before tax payers money is brought to bear. Yet previously European officials have indicated that Greece was unique in requiring a debt restructuring. Although at first European officials resisted the IMF's participation, now it seems that they are reluctant to proceed without it.”

Finally, he comments that the EU has been accused of playing political favourites. For example, some reports suggest that EU officials were aware of at least some of the deception of the conservative Greek government before 2009, but was reluctant to confront it for fear of bolstering the opposition Socialists. Chandler now feels that it appears European officials want to distance themselves from the Communist President of Cyprus, Christofias. Merkel for example, who will visit Cyprus later this week, is not expected to meet him. Cyprus will hold presidential elections on Feb 17. If no candidate receives 50% of the vote, which is the most likely scenario given recent poll results, a second round would be held on February 24th.

Chandler finishes by writing, “While last year we argued against the widespread view of a Greek exit, we are not as sanguine about Cyprus. Although one does not see it reflected in the survey or policy markets, we suspect the risks of a Cyprus exit are greater than currently appreciated.”