Cyprus which has a reputation for being a centre for money laundering from Eastern Europe, Russia in particular and other places as well has had a financial services sector and banking centre far greater than the size of its economy, seven to 8 times greater to be more precise. Two of its banks alone have assets more than 200 % each the size of the Cypriot GDP. Hence, they have a major case of too big to fail syndrome.(see the excellent note by Constantinos Stephanou the senior financial economist of the World Bank on secondement to the European financial stability Board in Cyprus economic policy review vol.5,#2 pp.122-130, ”The banking system in Cyprus:Time to rethink the business model”)

Its banks are now in trouble and the country (population 1.1 million people) which belongs to the euro zone had sought a bailout from its fellow euro members and the ECB and the IMF. As usual, the conditions involve imposing austerity including a rise in the corporate tax level, budget cuts but also a new twist which may well raise the alarm bells throughout Europe and beyond. All depositors are having to pay a 6.75 % tax on the value of their deposits to help finance the bailout. On accounts greater than 100,000 euros the rate of the tax rises to close to 10 %.
The tax is being deducted from accounts over this weekend and all electronic transfers are currently blocked to prevent withdrawals. Clearly, the suspicion that some of these larger deposits involve Europeans seeking to transfer funds to Cyprus to escape their being taxed at their point of origin or even being discovered is a partial motivation for the measure.The Euro zone officials would not agree to the bailout unless this tax was imposed.But the tax also hits smaller depositors and domestic Cypriots. It will not go unnoticed in financial circles in Europe and it may well provoke an erosion of confidence in banking generally.We shall see where this leads but once again it is an illustration of the dangers of allowing improperly regulated banks to operate and of the weakness of the euro monetary system.

It also illustrates deficit hysteria at work since the debt to GDP ratio in Cyprus based on gross debt which exaggerates the burden is as of third quarter 2012, 84.0 % up from 66.6 % in third quarter 2011. This is elevated but if the ECB were doing its job properly and had not imposed such severe austerity on Greece, which of course has close links to Cyprus, it would not be the threat it is turning out to be.

As of Sunday evening 5:40 Montreal time the Cypriot politicians appear to be insisting that the weight of the tax fall much more heavily on large depositors than small ones. One rumour suggests that the rate will be reduced to 3 % for depositors under 100,000 euros and raised to 12.5 % for large depositors. At least 19 of the members from the 56 member assembly are committed to voting no to any tax at all on depositors.A number of others are opposed to aspects of the tax. So the resolution remains a question mark for the time being. For his part the Archbishop of Nicosia , an influential leader has counseled that the assembly should vote to leave the euro and return to the Cyprus pre euro currency which would involve some currency depreciation for Cypriots owing debts in euros. We shall see how this turns out and how wide the repercussions will be.

Monday morning 11:01 Montreal time. Still no resolution of the impasse in the Cypriot parliament although it does appear that smaller depositors will be spared much of the tax that is likely to be levied on large depositors above 100,000 € . There is widespread anger in Cyprus over the original proposals.

Some analysts suggest it might be as high as 15 % for depositors above 500,000 €.  Russia has sharply criticized the proposal and is threatening to withdraw its support for the bailout. Markets are down worldwide on the uncertainty provoked by the proposed action, despite the fact that Cyprus is a tiny part of the European economy. It is not the size but the principal of violating the sanctity of bank deposits and reneging on deposit insurance guarantees and the fear that once this practice has occurred it might be repeated in Spain, Italy or Portugal or somewhere else that has people worried.