By Luke Baker
NICOSIA (Reuters) - Cyprus blamed the decision to restructure Greece's debt for destroying its own economy on Friday, and defended its right to seek financial assistance from Russia, calling it a strategic partner of the European Union.
Euro zone leaders agreed in late 2011 to write down the value of private-sector holdings of Greek government bonds to try to cut Greece's debt by around 100 billion euros - a process known as PSI, or private sector involvement.
It was a controversial decision and one that the former president of the European Central Bank, Jean-Claude Trichet, warned EU leaders could have severe repercussions.
For Cyprus, the euro zone's third smallest economy, with a GDP of just 17 billion euros and a large exposure to Greece, it meant Cypriot banks had to write off around 80 percent of the value of their Greek bond holdings.
That in turn made it harder to access inter-bank borrowing or to post collateral with the ECB for overnight liquidity. Cyprus now needs as much as 10 billion euros to restore order to its finance and banking sector, officials estimate.
The island of 1 million people has already taken a 2.5-billion-euro loan from Russia to help meet its financing costs, and Russia's finance minister said on Friday it was asking for a further 5 billion euros.
At the same time, Cyprus is in discussions with the EU about a bailout program, which is likely to come with much stricter conditions than the loan it has so far taken from Moscow. Cyprus has also hinted at talks with China and the Gulf states.
In Moscow, the head of the Russian finance ministry's debt department, Konstantin Vyshkovsky, said that in considering Cyprus' loan request, Russia would also take into the account the decision of the European Union.
Cypriot Finance Minister Vassos Shiarly, a former top banker, said Cyprus's economy, fuelled by a once-buoyant property sector and strong services industry, would not have run into such severe problems were it not for the PSI decision.
"Effectively, because of our close proximity, financial proximity to (Greece), we were called upon to pay a very heavy price," he told journalists during briefings in Nicosia as Cyprus takes over the presidency of the European Union.
"Cypriot banks that owned Greek sovereign bonds lost about 80 or 81 percent of their total investment, which in actual terms amounts to 4.2 billion euros," he said, pointing out that the sum was equivalent to a quarter of Cypriot output.
"The real problem stems from that particular investment. If you ask me whether this was a fair way to deal with it, I would say no, this was not a fair way of dealing with it."
Instead the minister argued that 100-billion-euro writedown of Greece's debt - a process that has not yet restored the country to debt-sustainability - should have been distributed on the basis of the size of each euro zone economy.
That would have meant Germany paying the most - around 27 percent of the total - and Cyprus just 0.2 percent.
"What we should have done is share that loss fairly, on a level playing field, as the Europeans do," Shiarly said.
"If our share had been fairly evaluated ... our total loss might have been in the order of 200 million euros - one would say petty cash these days."
Cypriot President Demetris Christofias, who was educated in Moscow, is the EU's only communist leader and has built close ties with Russia, firmly defended his decision to take aid from the country, calling it a strategic partner of the EU.
"We maintain the right to have relations with third countries," he said at a news conference with European Commission President Jose Manuel Barroso, smiling and touching Barroso on the arm to reassure him.
"I would like to say that in Russia what they have is a capitalist system. Don't worry, we won't be bringing communism to Cyprus because we are in relations with Russia. Please, they are restoring capitalism in Russia," he said.
On the same day that inspectors from the EU and International Monetary Fund finished their first fact-finding visit to Cyprus to establish how much aid it may need once a program is agreed, Christofias said Cyprus needed to be cut some slack and allowed to make its own decisions.
"Give us a bit of margin and allow us to resolve the financial problems our country is facing," he said.
(Additional reporting by Darya Korsunskaya. Editing by Jeremy Gaunt.)