* Cyprus fears escalate as markets rocked by rumors * Investors await vote on Cyprus bailout deal * Little impact from better-than-expected German ZEW By Gertrude Chavez-Dreyfuss NEW YORK, March 19 (Reuters) - The euro dropped to its lowest in more than three months against the dollar on Tuesday as investors nervously awaited a vote in Cyprus on a controversial bank deposit levy that renewed fears about euro zone instability. A Cyprus government spokesman said a plan to levy taxes on bank deposits, crucial for the country to secure financial aid, was unlikely to be approved by parliament on Tuesday. The House of Representatives was expected to meet at 1600 GMT. Rejection of the measure would push the island closer to a default and a banking collapse that could have repercussions across the euro zone. Traders cited a Market News International report on Tuesday quoting the Central Bank of Cyprus as saying that if the bill is not approved by parliament, it would leave the euro. There was also talk Cyprus' finance minister has offered to quit, all of which weighed on Europe's common currency. Cyprus' problems injected fresh volatility into financial markets, not only undermining the euro and European shares , but also supporting safe-haven German bunds. Some strategists, however, downplayed Cyprus' impact on the euro zone, even though there may be some uncertainty right now. "Cyprus is a small country and it's small enough to fail, but Italy is not," said Tom Higgins, global macro strategist and director of macroeconomic research at Standish Asset Management in Boston. Standish oversees $167 billion in assets. "If Cyprus leaves the euro, I don't think that poses a problem for the broader euro zone. I don't think this will lead to a general shift in risk sentiment." Higgins did say, however, that Standish was a little cautious about its peripheral holdings right now -- namely, Italy, Spain, Portugal, and Ireland -- because of the Cyprus situation. "But we think this is an area of opportunity for us if spreads widen (relative to German bunds), but we haven't really seen significant widening," he added, suggesting that the Cyprus story has had muted impact. The single currency fell to $1.2855, its lowest since November (Xetra: A0Z24E - news) 22. It was last at $1.2868, down 0.7 percent. Sebastien Galy, currency strategist, at Societe Generale (Paris: FR0000130809 - news) in New York remained hopeful, convinced that the impact has been limited so far. "If you look at the bond market, it looks to me that there is limited contagion at this point in time." Even though German bunds were higher, Spanish and Italian bonds were generally holding steady on the day, nothing crazy. Spanish 10-year yields were flat at 5.04 percent, while their Italian equivalents were slightly higher at 4.71 percent. Some analysts said the market remains insulated by the European Central Bank's as-yet untested promise to buy government bonds in potentially unlimited amounts, if necessary, to help stabilize financial markets. Earlier, the euro briefly gained after a slightly better-than-expected German ZEW economic sentiment survey, but demand was hampered by worries about Cyprus. Against sterling, which is currently being bought as a shelter in times of heightened uncertainty in the euro zone, the euro fell to a five-week low of 85.02 pence. It was last at 85.11 pence, down 0.9 percent. The euro also retreated against the Swiss franc, dropping 0.6 percent on the day to 1.2180 francs. UPHILL TASK Analysts said the unprecedented plan to impose taxes on citizens' savings in Cyprus, announced over the weekend, had rattled savers in larger European countries also burdened by heavy debts, like Spain and Italy. As a result, the more liquid dollar and the Japanese yen, often sought during times of financial instability and economic stress, should remain supported. The dollar index, which measures the greenback against a basket of currencies, was up 0.4 percent at 82.987. The dollar slipped 0.2 percent versus yen at 94.98 yen , with the Japanese currency likely to be driven by any comments from incoming governor of the Bank of Japan Haruhiko Kuroda, who assumes the post on Wednesday. Expectations are huge for Kuroda to put in place an aggressive monetary policy to try and lift Japan out of deflation and which is likely to weaken the yen. Market players said if the situation deteriorates in Cyprus the safe-haven yen could regain ground, pushing the dollar further away from last week's 3-1/2 year high of 96.71 yen. Meanwhile, the U.S. economy continued to show outperformance on Tuesday, with housing starts rising last month and new permits for construction climbing to their highest in more than four years. The report briefly boosted the dollar against the yen.