Although many investors couldn’t find Cyprus on a map, this island nation in the Mediterranean has become the latest smoldering ember in the European tinderbox. It’s a small member of the EU, but a big headache for the entire Continent.

With its economy closely tied to that of nearby Greece, Cyprus lost EUR4.5 billion on its Greek bonds after being forced to take a haircut on them in the second Greek bailout. Now, Cypriot banks have found themselves in a crisis of their own.

What’s more, the Cypriot government is already deeply indebted, with a debt-to-gross domestic product (GDP) ratio of 127 percent—the second worst in Europe, behind only Greece.

Considering Cyprus’s population is only 1.1 million and its GDP last year was valued at a meager EUR17.5 billion, that’s a crisis of epic proportions and one which has been made worse by the proposed cure.

The European Troika—the European Commission, the International Monetary Fund and the European Central Bank—agreed to a EUR10 billion bailout on the condition that the Cypriot government impose a one-time banking tax on all of the country’s savers. Under the plan, depositors with less than EUR100,000 in their accounts would be subject to a levy of 6.75 percent on their savings while those with more than EUR100,000 in deposits would be taxed at 9.9 percent.

Granted, the depositors wouldn’t walk away empty handed, since they would be given bank shares in exchange for the funds, but who wants shares of bankrupt banks?

It’s estimated that the one-time tax would have raised EUR5.8 billion, but word leaking of the proposal sparked a bank run, forcing the government to close all of the country’s banks this past Friday. Outraged depositors took to the streets in protest.

Cypriot President Nicos Anastasiades, who had only been in office for a couple of weeks before the crisis came to a head, agreed to the plan and it was put to a parliamentarian vote yesterday. While the bailout would have gone a long way towards righting the budgetary ship, members of parliament could feel the prevailing political winds. Although there were 19 abstentions, not a single member voted in its favor. That outcome was little surprising, considering the first goal of most politicians is to be reelected and a savings grab isn’t particularly popular with the electorate.

In theory, it makes sense that local citizens be asked to help finance the solution to a local problem, even one with broader regional implications. As with the American government after the 2008 financial meltdown, when Washington bailed out failing banks, Cypriot’s leaders faced a tough choice: hold their noses and implement an unpalatable solution, or let a catastrophe unfold.

Then again, it’s understandable that the Cypriots would see the bailout as a betrayal, since no other country’s citizens have been asked to directly bear the cost of recent bailouts. It’s also a bit of a slap in the face, because European officials have been making every effort to ensure that depositors don’t directly bear the burden.

So what makes Cyprus different?

In addition to its miniscule population, the country is geographically removed from Europe proper. Its banking system also is one of the least efficient in the region, with liabilities of more than eight times the country’s economic output.

Today, about half the country’s bank deposits are believed to belong to non-Cypriots. It’s a particularly popular banking haven for the Russians, who aren’t beloved by the EU, given Russia’s propensity to play “gotcha” with its natural gas. Under President Putin, this vast petro-state has been working to build its own regional power block, reminiscent of the old Warsaw Pact.

The sheer size of the Cypriot bailout, equal to nearly a full year’s worth of Cypriot GDP, understandably makes the Troika nervous.

The Troika also saw a possible mitigating circumstance, in that a large natural gas reserve in the country should soon be under production and a portion of those revenues could ultimately be used to refund depositors. But those gas reserves are a pie-in-the-sky promise, because it’s still uncertain just how much gas lies under the island and proven reserves are currently subject to rights disputes.

Regardless of the circumstances, it’s tough to understand how anyone thought the plan, reminiscent of the ham-handed stunts of dictatorships, would ever fly.

German Schadenfreude?

How the crisis is resolved remains uncertain. One thing is certain, though: putting the screws to the tiny country of Cyprus would be hugely popular with the electorate in Germany, a country that still serves as the EU’s growth engine.

Elections are fast approaching in Germany and the public there is increasingly impatient with what seems like an endless string of bailouts. It’s easy to see why Germans might be tired of footing the bill, but then again, Germany’s tight labor protections and loose trading restrictions with other EU nations has made it a major contributor to the crisis.

The more solvent banks in the Europe’s core have also proven ready and willing to lend to even marginal borrowers, both sovereign and private, because the wealth created by the loans has largely flowed back to the center.

At this point, there’s no “Plan B” on the table for resolving the crisis in Cyprus. It’s possible that Russia might ultimately step in with a bailout of its own, given the sheer number of Russian bank depositors in the country, but that seems unlikely. While Cyprus’s previous president was decidedly pro-Moscow, Anastasiades clearly favors the West.

The Cypriots might come back to the table with the idea of a banking tax, especially one that only affects larger depositors, but that seems unlikely as well. One of the reasons the country’s banking system has gotten so out of control is because it has worked to build a reputation as an international financial center and it would be severely tarnished by a cash grab.

Allowing the Cypriot banking system to collapse would probably trigger another broad banking crisis, so it hardly seems to be in the EU’s favor to allow the situation to fester. Cyprus may be a tiny island, but a banking crisis there would shake confidence in every banking system, even our own. I suspect the EU will ultimately relent on the bank tax idea and offer the bailout on more favorable terms.

Regardless of how or when this most recent crisis is solved, it’s a clear reminder that there are still weak spots in the global financial system, even if the markets have become rather complacent on the matter.

Portfolio Roundup

Companhia Energetica Minas Gerais (NYSE: CIG), otherwise known as CEMIG, took a sharp dive yesterday after analysts at two Brazilian banks released research notes forecasting that the Brazilian government would continue to curb electricity rate increases in the country. That sparked a selloff across all electric power companies in the country and pushed the Brazilian Bovespa Index to a two-week low.

On a recent conference call, CEMIG’s chief financial officer said that the company’s growth and earnings forecasts built in the possibility that the government would continue keeping rates down, which means the market was overreacting to the news.

So far, the rate curbs remain just speculation, but they’re not an entirely idle concern because Brazilian authorities have been increasingly willing of late to intervene in the economy to keep inflation in check and prop up lagging growth.

Only a month ago, many analysts were predicting high Brazilian power prices after the upcoming rate review by the government, so it’s still anyone’s bet as to whether the decision will come down on the side of rate increases or standing pat.

Despite the rate uncertainty, the current pace of economic growth in Brazil allows CEMIG to grow its earnings on volume if not on margin. Companhia Energetica Minas Gerais remains a buy under 15.