Felix Salmon has a tantalizing tidbit about Olli Rehn, European commissioner for economic and monetary affairs, apparently conceding that a Cypriot default is now virtually inevitable, less than a month before the Cypriot presidential election:

EU economics commissioner Olli Rehn went on the record telling him that Cyprus is going to have to restructure its debt — just two weeks after ruling such a thing out.

That might come as little surprise, given that Cypriot banks were loaded up to the gills with Greek debt, and Greek debt suffered a 70% haircut. Cyprus is tiny, and could never afford the €17 billion needed to bail out the banks and the government — especially since that would bring the country’s debt load up to more than 140% of GDP.

Salmon cites a report from The Wall Street Journal‘s Stephen Fidler reporting from Davos.

The Republic of Cyprus, with just over 800,000 people, is the third-smallest member of the eurozone (after Malta and Luxembourg), and it’s a relative newcomer to the single currency, having replaced the Cypriot pound for the euro only in January 2008, although the Turkish-controlled northern part of the island still uses the Turkish lira.

The country accounts for just 0.2% of the eurozone economy, though its GDP per capita is a relatively wealthy $29,000, and it’s been in negotiations for a bailout for some time now.  That hasn’t yet been successful, in part because of the unique legal, political and financial complexity of the negotiations.

Rehn’s statement, if true, is essentially a declaration that time has run out — Moody’s downgraded Cypriot debt in July 2011 to junk status.

Nonetheless, a €17 billion bailout would be dwarfed by the Greek bailout (€245.6 billion), the Spanish bailout in July 2012 to provide liquidity to Bankia (€41 billion), and even the bailout provided by the ‘troika’ of the European Commission, the European Central Bank and the International Monetary Fund of Romania that began in 2009 (around €20 billion).

In many ways, a Cypriot default will be a key test for the European Union, given that it would be the first default since the treaty establishing the European Stability Mechanism formally came into effect at the end of September 2012.

Unlike in Greece, where much of its debt is governed by Greek law, much of Cypriot debt is governed under various international law, which will make it a messier restructuring.

Keep in mind, also, that the island of Cyprus remains split between the Republic of Cyprus (largely populated by Greek Cypriots) and the Turkish-occupied northern half of the island, the Turkish Republic of Northern Cyprus (largely populated by Turkish Cypriots).  The island has been divided since a 1974 coup, Greece’s attempt to annex the entire island, and Turkey’s subsequent invasion, and the formal declaration of Northern Cyprus’s independence in 1983.

Add to that the fact that Cyprus is seen as a hub for worldwide money laundering, especially with respect to illicit funds from Russia, despite the protestations of Panicos Demetriades, president of the Central Bank of Cyprus, earlier this week.

That means bailout proceeds could go directly into the pockets of some of Russia’s wealthiest oligarchs, a position that’s unlikely to go down well politically throughout the rest of the eurozone, especially as Germany gears up for federal elections later this year — German officials have even demanded that Russia contribute to any Cypriot bailout.

Meanwhile, Cyprus will go to the polls in less than a month to replace Demetris Christofias, the country’s left-wing president since 2008.  Unlike in many European countries with parliamentary systems, Cyprus’s president is both head of state and head of government.

With a default (orderly or otherwise) on the horizon, Cyprus now faces a presidential election on February 17 — with a runoff, if necessary, a week later on February 24 — in the midst of a financial crisis and perhaps in the midst of bank runs.

Christofias, who has presided over economic turmoil and an unemployment rate that’s now at 14%, has so far refused to engage in massive privatizations of state-run industries as a condition for a potential bailout.

Add all of those factors together — the size of the Cypriot banking sector’s debt, the legal complexity of the debt, the Russian laundering issue, the complexity of the Turkish political reality with Northern Cyprus, and the leftism of the Christofias administration — and you start to understand why Cyprus is now allegedly headed to a default.

The frontrunner in the presidential election, for the moment, is Nicos Anastasiades, candidate of the center-right Democratic Rally (DISY, Δημοκρατικός Συναγερμός or Dimokratikós Sinayermós), who has the support of many European leaders, including German chancellor Angela Merkel.  It’s believed that bailout negotiations would certainly be much easier with Anastasiades as president, as opposed to Christofias or any of the leftist alternative running for president.

But polls show Anastasiades unlikely to earn more than the 50% necessary to win the election in the first round outright.  Anastasiades’s current strength is due, in part, because leftist voters are currently split between the two candidates lagging in second place: Stavros Malas, minister of health since August 2011, the candidate of the leftist Progressive Party of Working People (AKEL, Aνορθωτικό Κόμμα Εργαζόμενου Λαού or Anorthotikó Kómma Ergazómenou Laoú) and Giorgos Lillikas, another center-left candidate and former foreign minister from 2006 to 2007, backed by a coalition of small centrist and leftist parties, including the center-left Movement for Social Democracy (EDEK, Κινήμα Σοσιαλδημοκρατών or Kinima Sosialdimokraton).

By pushing Cyprus closer to a default, European policymakers may well be nudging Cypriot voters to blame the already-unpopular Christofias and, potentially, Malas, as the candidate of the governing AKEL, especially if the race ends in a runoff between Malas and Anastasiades.

Scope out to Europe, however, and it’s clear that a Cypriot default could cause additional ‘moral hazard’ problems, and it wouldn’t be surprising to see skittish investors send 10-year bond rates in Spain, Italy and elsewhere in the eurozone a little higher as the terms of any Cypriot default become clearer.  As Salmon notes, the EU allowed the Greece restructuring on a ‘unique and exceptional’ basis.

True, but in some ways, a restructuring of the banking system in Cyprus was the natural result of the Greek restructuring, given that Cypriot banks were so heavily exposed to Greek debt — Moody’s cited that exposure as one of the chief reasons for downgrading Cypriot sovereign debt back in 2011.  On that basis, European leaders can argue that this is just an extension of the original ‘unique and exceptional basis.’

But following a Cypriot restructuring, it would be easier to believe that further haircuts might come — and not only for Greek sovereign debt, but also, perhaps, for the still-troubled Spanish banking sector and, after all, a Spanish banking default would have much wider consequences for the eurozone’s stability.

This is one reason, by the way, that Spanish prime minister Mariano Rajoy has been so insistent that he will not seek a bailout for Spain from the EU or from the ECB — he has more leverage with Brussels and Berlin today than his did yesterday.  It’s also much better for Rajoy politically to find a direct workout for the Spanish banking system from the ECB directly than for the Spanish government to assume the debts directly and then be forced into a sovereign bailout, with potentially even harsher conditions imposed on it than the tax hikes and budget cuts it’s already implementing (in addition to perhaps the most volatile European independence movement based in Catalunya and with unemployment rising to its highest level yet at 26%).

It’s also another reason why it’s easy to believe Greek opposition leader Alexis Tsipras when he goes around the world telling everyone that Brussels and Berlin will countenance a haircut of Greek public debt eventually, even if it has to come after Germany’s federal elections expected later this autumn (Merkel certainly doesn’t want to face the wrath of German voters by granting further financial leniency to Greece at the same time that the German economy itself is tottering on recession).

Salmon noted the wider consequences as well that a Cypriot default would entail for European policymakers — above all,  Cyprus, despite its small economy, could well become the precedent for eurozone exit:

So even if Europe has made its first big decision — to force Cyprus to default — it still faces many more. Should it amend the ESM treaty to make any restructuring easier? Should it impose a haircut on Cyprus’s uninsured depositors? And how can it structure the process to minimize the chances of a messy bank run, default, and possibly even exit from the euro? It’s easy to dismiss Cyprus as too small to worry about. But it’s still an important sovereign state. And if the EU missteps on Cyprus, that would bode very ill for any similar problems in bigger eurozone countries in the future.