[ed. As one journalist noted, this isn't a tax, it's theft. Ostensibly directed at Russian depositers, the common Cypriot resident will likely get hosed in the process. It remains to be seen how other EU countries will view this development. As Paul Krugman notes, if you want to start a run on the banks this is a good way to do it.]
Since June 2012, it has been known that Cyprus needs around Euro 17-18 billion to recapitalise its banks (around Euro 10 billion) and for general government operations including debt servicing (around Euro 7-8 billion). While small in nominal terms and well within EU’s resources, the amount is large relative to Cyprus’ Gross Domestic Product (“GDP”) of Euro 18 billion. It is unlikely that Cyprus can realistically repay it, in the absence of a dramatic change in its circumstances such as the mooted oil and gas reserves in the Eastern Mediterranean.
The various options considered to generate the required funding included: privatisation of state assets, increases in corporate taxes (from 10% to 12.5%) and withholding taxes on capital income (to 28%) and restructuring of existing bank or sovereign debt. Debt restructuring options included a “bail-in” of creditors (the new fashionable term for a write off of principal). It would also entail easing terms and lengthening maturities of (up to) Euro 30 billion in loans from Russian banks to Cypriot companies of Russian origin.
The package proposed by the EU incorporates almost all of the above measures. Most controversially, ordinary depositors will face a “tax” on Cypriot bank deposits, amounting to a permanent write down in the nominal value of their deposits. The deposit levy will be 6.75% on deposits of less than Euro 100,000 (the ceiling for European Union account insurance) and 9.9% for deposits above that amount. In return, the depositors will receive shares in the relevant banks.
The unprecedented write down of bank deposits expected to raise around Euro 5.8 billion is motivated by a number of factors. (...)
Whatever the case for the Cyprus package, it risks significant side effects.
Firstly, it may trigger capital flight from banks in Greece, Portugal, Ireland, Italy and Spain, based on depositor concerns about loss of capital in any future debt restructuring.
Europe has total bank deposits of around Euro 8 trillion, including around Euro 6 trillion in retail deposits. Around Euro 1.5-2 trillion of these deposits are in banks in peripheral countries.
In the period leading up to July 2012 banks, these peripheral countries lost between 10% and 20% of their deposits. This only abated when the ECB made its extraordinary announcement in July 2013 that it would do whatever it takes to safeguard the Euro.
If depositors withdraw funds in significant size and capital flight accelerates, then the ECB, national central banks and governments will have intervene, funding affected banks and potentially restricting withdrawals, electronic funds transfers and imposing cross-border capital controls.
