Never in a million years did anyone in Europe think that a small island at the butt-end of the Mediterranean, one much closer to Ankara, Beirut and Damascus than to any European capital, could rewrite the euro zone bailout rules virtually overnight. But it has.
The fallout from Cyprus's piddling €10-billion bailout has rattled the European markets, sent the euro sliding and raised this question among tens of millions of bank customers in Spain, Italy, Portugal, Slovenia and other countries on the euro zone's rotting southern frontier: Could it happen to us too?
The answer: Why not?
Cyprus rewrote the bailout rules by confiscating a portion of bank deposits; no euro zone country had resorted to such barbaric behaviour since the common currency was born 14 years ago.
At first, the raid was to hit all deposits, including the allegedly insured ones under €100,000. Then the European Union, the International Monetary Fund and the Cypriot government backed off the idea, for fear their offices would be torched.
Plan B spared the insured depositors at the expense of the uninsured ones – those holding more than €100,000. That was especially bad news for the Russians, who had made Cyprus their favourite offshore banking centre. Moody's estimated they had €25-billion stuffed in Cypriot banks. But no one felt sorry for them.
The bailout will see the death of Cyprus's second-largest bank, Popular Bank. The "good" assets, including the insured deposits, will be delivered to the leading commercial player, Bank of Cyprus.
The "bad" bits, including the uninsured deposits, will be sent to the blast furnace. The uninsured depositors at the new Bank of Cyprus stand to lose as much as 40 per cent. Bondholders and shareholders of both banks will be wiped out.
The deposit raid triggered anxiety attacks across Europe.
A poll in Spain, whose banks were bailed out last year, found that 65 per cent of Spaniards feared that what happened in Cyprus could happen to them. Italians apparently were not polled, but it is unimaginable that they would think any differently as their recession – Europe's second worst, after Greece – deepens and one of their biggest banks, Monte dei Paschi di Siena, does a credible imitation of SS Andrea Doria.
Italians have seen this playbook before; in 1992, during one of its periodic fiscal clean-ups, the government slapped a 0.6-per-cent tax on deposits. It was small enough not to cause riots and did the trick. A haircut of 40 per cent, like the one contemplated at Bank of Cyprus, is an entirely different matter.
The Cyprus-style haircut should not be condemned as evil and unworkable. In desperate times, desperate measures have to be taken. Minus the bank restructuring and deposit raid, the Cypriot bailout loan would have climbed to perhaps €17-billion – the equivalent of almost 100 per cent of the island's gross domestic product – from €10-billion. The debt, piled onto an economy already in recession, would have overwhelmed Cyprus, no doubt ensuring a second bailout or worse – exit from the euro zone.
Politics is working in favour of deposit haircuts. Europeans, especially those in the south, but also those in Britain, are weary of austerity. Austerity has sent economies into recession and the jobless rate to record high levels in more than a few European countries. Sadly, austerity is the prescribed trade-off for sovereign bailouts and bank bailouts.
If Spain or Italy were offered the choice between another lashing of brutal austerity to pay for the mistakes of the banks, or foisting the cost on bank depositors, shareholders and creditors, the latter might win.
Of course, the decision is not that easy. If the depositors' haircut is 1 per cent or 2 per cent, it would be an easy sell; anything higher would not. And if the haircut comes with Cypriot-style capital controls, the price of the haircut would go up exponentially. Capital controls deny you full access to your cash. In effect, they mean that your euros are worth less in, say, a Spanish bank than elsewhere in the euro zone. Capital controls have so debased the value of Cyprus's euro that you can make the argument that Cyprus is no longer part of the euro zone.
Because of Cyprus, a sobering new reality has hit the currency union: There are no bailout rules any more and nothing is sacred. No wonder bank depositors are running scared and bank shares are sinking. The real problem will come if the Spanish and Italian economies keep deteriorating and "bailout" starts rolling off the lips of economists and investors.
The Cyprus bailout was probably the right thing for the country and the rest of the euro zone, whose taxpayers were in no mood to fund another high-priced bailout. But it also created potential new problems in Europe by increasing the odds of a bank run. Once a bank run starts, it tends to keep running, with ugly results. Cyprus has given Europe a new nightmare scenario.
Eric Reguly