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Cypriot flags fly as a protester shouts slogans during an anti-bailout rally outside the parliament in Nicosia, March 22, 2013. Cypriot leaders are discussing with their international lenders the adoption of a levy of more than 10 per cent on bank deposits over €100,000 ($130,000), a ruling party official said on Friday, as the island scrambles to clinch a European Union bailout. (YANNIS BEHRAKIS/REUTERS)
Cypriot flags fly as a protester shouts slogans during an anti-bailout rally outside the parliament in Nicosia, March 22, 2013. Cypriot leaders are discussing with their international lenders the adoption of a levy of more than 10 per cent on bank deposits over €100,000 ($130,000), a ruling party official said on Friday, as the island scrambles to clinch a European Union bailout. (YANNIS BEHRAKIS/REUTERS)

EUROPEAN DEBT CRISIS

Cyprus bank mess makes all the other euro dominoes teeter dangerously Add to ...

When Greece rudely invented the debt crisis in 2009, Cyprus was completely irrelevant to the story. It is now coming close to becoming the first country to leave the euro zone. If it does, the cherished, oft-repeated notion the euro is irreversible would go down the toilet. If Cyprus, why not Greece or Portugal or any other feckless financial failure?

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Why Cyprus chose, or was encouraged, to adopt the euro is a mystery, especially since it was rolling merrily forward with the Cypriot pound. Perhaps the euro zone’s masters in Brussels and Berlin decided it would be in the region’s best interests to have an in-house money-laundering centre to deal with those, you know, awkward little income streams.

So into the monetary union it went, in early 2008, only to be forgotten. How could a sunny lump of sand and soil on the eastern fringe of the Mediterranean – worth a mere 0.2 per cent of euro zone economic output – possibly be a problem? Evidently no one looked at Cypriot banks, stuffed to the sun umbrellas with foreign deposits, including an estimated €25-billion ($33-billion) from Russians alone. The numbers were eye-watering: Deposits at four times GDP, total assets at seven times GDP.

Translation: Little country, big problem.

Still, the euro zone didn’t get it, even if Cyprus itself figured out that trouble was afoot as its banks, holed at the waterline by near-worthless Greek sovereign bonds, began to slip below the waves.

Two years ago, Cyprus convinced Russia to hand it a €2.5-billion loan. About a year ago, the euro zone decided to pay attention, but apparently could not decide whether the island could be declared an emergency situation.

Now it has. On Thursday, the European Central Bank said it would withdraw the Cypriot banks’ emergency liquidity lines on Monday unless the Nicosia government produces a credible bailout plan to replace the one it had ditched in a parliamentary vote only two days before.

The pity is that the original plan concocted by the euro zone, the International Monetary Fund and the Cypriot government was not that bad, as distressingly late as it came. But it contained a flaw that ultimately killed it – the tax on bank deposits of the non-rich. If that flaw had been corrected, Cyprus might be in the recovery ward already.

Stress tests determined that the Cypriot banks required as much as €12-billion in capital; another €5-billion or so was needed for the state itself. Slathering that amount onto Cyprus would cripple the country, taking its debt-to-GDP ratio to Greek levels, and we all know what happened to Greece. So a novel hybrid plan was concocted. The euro zone and the IMF would offer €10-billion if Cyprus itself came up with €5.8-billion, give or take a few euros.

But where would it come from? The rich deposit base was ripe for the picking. It would get get hit with a tax. The plan would not be unprecedented. In 1992, Italy, in an effort to clean up its fiscal act, slapped a one-off, 0.6-per-cent tax on bank deposits.

But the Cypriot version was a monster in comparison: a 6.75-per-cent levy on deposits under €100,000 and 9.9 per cent on those over that figure. It came as a shock to Cypriots and foreign depositors (read: Russian). No other bailout had been partly financed by outright confiscation of bank customers’ savings. Worse, it made a mockery of the insurance scheme that guaranteed deposits up to €100,000. Cypriots were enraged and lawmakers, backed into a trap of their own making, overwhelmingly voted against the bailout.

Taxing small depositors, the people who are suffering most in the Cypriot recession – the unemployment rate has tripled to more than 12 per cent since 2008 – was nothing short of disgusting. Going after the deposits of wealthy foreigners was not.

Why did the government not just limit the tax to wealthy depositors, and put it at about 15 per cent? Because it feared scaring away foreigners and jeopardizing Cyprus’s status as a thriving (regulation-light) international financial centre. Whether the tax is revived or not, foreigners are bound to flee anyway because they have lost confidence in the Cypriot banking system.

By the end of the week, as the banks remained closed, the government was toying with increasingly desperate measures to replace the missing €5.8-billion that was to be funded by the tax. There was talk of issuing bonds whose payments would be linked to future offshore natural gas revenues which would not come until the end of the decade, and raiding the pension funds. A mess, in other words.

While a bailout deal is still possible by the ECB’s Monday deadline, it is bound to be deeply flawed. Or it might not exist, in which case the Cypriot banks will die a quick death, the economy will go into free-fall and Cyprus could be out of the euro zone within days, with the attendant contagion effects in Greece and other teetering economies.

Allowing Cyprus to get to this point shows epic incompetence on all sides. The proposal to whack the deposits of the poor and working-class families was morally repulsive. The problem could have been snuffed out a year or two ago at much less expense. Instead it was allowed to fester, then explode. If the bailout of a little country like Cyprus can be so easily botched, what will happen when Italy and Spain fall apart?

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