REFILE-ANALYSIS-Cyprus rescue may set unwelcome euro zone precedent
(Edits first and second paragraphs)
* Cyprus aid options to set precedent for other troubled states
* Loan could make Cyprus debt unaffordably high
* Debt writedown would break promise that Greek deal was one-off
* Hitting bank depositors could sow panic elsewhere
* First round of Cypriot presidential elections on Feb 17
ATHENS/NICOSIA, Feb 13 (Reuters) - Cyprus hardly seems to have the sort of debt crisis that could provoke a domino effect across the euro zone; its economy is tiny and the bloc's financial exposure to the island is modest.
Nevertheless, Cyprus is fast becoming a risk for efforts to tackle problems in the euro zone's much larger economies because almost any way of solving the crisis - from restructuring its debts to imposing losses on banks - is likely to set a precedent for other troubled states.
The danger is that a rescue for Cyprus, which heads to the polls on Sunday, will hurt fragile confidence on financial markets and undermine progress that the euro zone has made in shoring up the rest of its "peripheral" members.
"It's not a big issue in terms of financial exposure, but it sets a precedent for what happens in other countries," said Jennifer McKeown, a senior economist at Capital Economics.
"At a time when financial market sentiment is just starting to improve, with the feeling that Greece is getting out of the woods and things are improving in Spain, it would be a real shame if they couldn't come up with a solution for Cyprus."
Cyprus applied for international financial aid eight months ago, after Greece's sovereign debt restructuring caused huge losses for its banks. The island needs up to 10 billion euros to shore up the banks and a further 7.5 billion for its budget.
At first glance, Cyprus poses little threat to a bloc used to firefighting in far bigger economies such as Spain and Italy.
Its 18-billion euro economy accounts for less than 0.2 percent of the bloc's output, while euro zone banks' exposure to Cyprus - including lending to banks, companies and households - is estimated at less than 0.1 percent of euro zone GDP.
The biggest banks in Greece - the euro zone country with the closest ties to Cyprus - each have small retail units on the island but minimal exposure to its sovereign debt, several Greek bankers familiar with the matter said.
Even the possible size of a Cypriot bailout - 17 billion euros - is a fraction of the about 240 billion euros ($323 billion) that the euro zone and International Monetary Fund are pumping into the bloc's problem child, Greece.
DEAD END SOLUTIONS
The trouble begins with the form of aid needed. A loan would push Cypriot debt to as much as 140 percent of its annual gross domestic product. This would make it hard for the IMF to take part in the rescue, as the Fund has rules against making loans to countries which it believes will not be repaid.
Debt relief for Cyprus would also be problematic because of the message it would send to the rest of the euro zone. Any restructuring along the lines of last year's deal for Athens, when private bondholders were forced to accept heavy writedowns in the value of their Greek government debt - would belie policymakers' promises that this was a one-off event.
It would also not work since most of the Cyprus government debt is held by Cypriot banks, which already need bailing out.
Imposing losses on bank depositors - an option ruled out by Nicosia and European officials this week - could similarly spook markets and prompt people to pull their savings out of banks in other weak euro zone countries.
"The way the euro area deals with Cyprus is going to provide a number of signals to the market as to what will happen next in future bailout cases," said Platon Monokroussos, head of financial markets research at Eurobank in Athens.
Senior policymakers including European Central Bank executive board member Joerg Asmussen have begun warning against complacency on Cyprus.
The island's financial troubles have loomed large in campaigning for this month's presidential elections, where opinion polls show right-wing opposition leader Nicos Anastasiades - the most pro-bailout figure among the top three contenders - in the lead.
If successful, Anastasiades, who has criticised the incumbent left-wing government for stalling on a deal with the EU and IMF, would have to sign off on a bailout before June when the country has to make a 1.4 billion euro debt repayment.
Even without the problems of structuring the aid, a bailout is proving tricky due to the country's links to Russia, the disproportionately vast scale of its financial sector and German misgivings over its commitment to fighting money laundering.
Politicians in Germany, which funds a large part of euro zone rescues, are scathing about the island's role as a magnet for Russian offshore funds they claim are of dubious provenance.
Plumped up with Russian money, an inflated Cypriot banking system hoarded huge quantities of Greek debt. When that was written down in early 2012, the island suffered mammoth losses. In bailing out Cyprus, the German logic goes, the euro zone will also bail out Russian oligarchs who park their money there.
Analysts expect a deal to avoid a Cypriot bankruptcy will be reached sooner or later, but talks have struggled on issues including the size of the banking system.
Latest data shows the Cypriot banking sector's assets amount to about 146.2 billion euros - or about 820 percent of GDP - making it one of the biggest risks to the island's economy.
Adding to its vulnerability is the relatively high level of private sector loans - worth 48.5 billion euros or 270 percent of the economy, data shows. Policymakers such as Asmussen have also pointed to Greek-Cypriot banking links as a route for possible contagion, though bankers on both sides play this down.
Greek bankers say the biggest risk they expect is a jump in bad loans in their Cypriot retail units due to a recession deepened by austerity measures that are likely to be demanded under bailout deal.
Retail exposure of Greece's four biggest banks in Cyprus remains small. Together they held 10 percent of deposits and 13 percent of loans - while Cyprus's two biggest banks in turn held less than 10 percent of deposits and loans in Greece, according to a Merit consultancy report based on 2011 data.
If Cypriot banks were allowed to fail, Greek depositors would risk losing their money - but the bigger fear remains panic in Greece from allowing major banks to fail rather than the impact from direct banking links, some bankers said.
"If that happens, then everybody will start thinking that Greece will be next," said a senior Greek banker who declined to be named. "Trust will be shaken and that will trigger a bank run in Greece and the euro zone periphery."
Policymakers such as Asmussen have said Nicosia will have to fulfils tough conditions for aid, including introducing more banking transparency.
But analysts warn that demanding too much from Cyprus could backfire and lead to speculation that it could leave the euro zone, just as fears of a Greek exit are easing.
"If Cyprus is given a very tough deal in which it is has to do much more austerity, then there will be a temptation to leave the euro zone and the question is whether markets can overlook that, given Cyprus is a very special situation," said McKeown.
"There's a risk that the departure of just one country - however small - leads to wider fears of a euro zone breakup." ($1 = 0.7427 euros) (Additional reporting by Lefteris Papadimas in Athens; editing by David Stamp)
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