How can they do that?! A look at Cyprus' decision to tax depositors

Published March 16, 2013

| Associated Press

Cyprus' eurozone partners and the IMF agreed early Saturday to bail out Cyprus to the tune of €10 billion ($13 billion) — largely to prop up its flailing banking industry. But the deal, as usual, comes with strings attached. The one causing the most consternation is a levy on bank deposits held in Cypriot accounts. Here's a look at how that will work — and the problems it may pose.

HEY, HOW CAN THEY DO THAT?

Currently, all 17 European Union countries that use the euro offer deposit insurance to protect customers if their bank fails. But the measure in the Cyprus deal is a tax — not losses incurred because of a bank failure. In fact, it's meant to hold off a bank collapse. Countries have the right to raise or lower taxes whenever they want. Just ask the residents of Greece, Portugal and Ireland — all bailout recipients — who saw their tax bills skyrocket as those countries tried to reduce their debts. But Cyprus is charting new ground here, and there could be legal — and political — challenges.

AND HOW EXACTLY WILL THEY DO THAT?

Banks have already acted to seal off the amount of the levy — a 6.75 percent tax on deposits under €100,000 and 9.9 percent on those above — so depositors can't access it. Bank customers still can draw on the rest of their funds via ATM machines this weekend, and nervous depositors did that on Saturday to drain their accounts. But the few banks that opened on Saturdays did so only briefly, and no international transfers will be able to go through until Tuesday, since Monday is a holiday. Cyprus' Parliament is expected to meet Sunday to pass the required legislation. The deal also needs the approval of several eurozone parliaments; it's unclear how fast they can act and what will happen to bank deposits in the meantime.

HAS THIS EVER HAPPENED BEFORE?

So far in the euro crisis, depositors have been protected. But in the 1990s, Italy levied a tax on every bank account to stave off the collapse of its lire currency. The rate, however, was minuscule — 0.06 percent — compared to what Cyprus is enacting. Iceland — another island with an outsized financial sector, although worse weather — also relied on depositors to prop up its banks. When the crisis hit there in 2008, Iceland protected its domestic deposits but reneged on deposit insurance for overseas, Internet-based accounts held by British and Dutch. Those two governments stepped in to help their citizens to the tune of $5 billion. The U.K. and the Netherlands sued Iceland unsuccessfully in a European court to get their money back, but Iceland has nevertheless started to repay some of that money.

European officials are promising that Cyprus is a unique case, and they are right in one aspect: the country's banks are overwhelmingly funded by deposits, so it wouldn't have been very fruitful to go after bondholders.

WHO IS AFFECTED?

All depositors — except those in Greek branches, which will be sold to Greek banks. EU and IMF creditors clearly wanted to protect struggling Greece, but perhaps also saw that Greece is the most likely place in the eurozone for a bank run. Protecting depositors there minimizes that possibility. Of the about €68 billion on deposit in Cypriot banks, foreigners hold about 40 percent — and most of those are Russians. Cyprus could have only gone after non-EU depositors, but it may have been hard to distinguish between Cypriot and Russian savers, Jacob Kirkegaard said, since many Russians have dual citizenship and many Russian businesses are registered on the island. Kirkegaard, who is a senior fellow at the Peterson Institute for International Economics in Washington, said Cypriots may paradoxically welcome this measure since the government just managed to widen its tax base to include a lot of Russians; the taxes levied in Greece, Portugal and Ireland were for residents alone to shoulder.

WHY DID CYPRUS NEED A BAILOUT?

Cyprus built its economy in recent years by becoming a financial center, much the way Ireland and Iceland had done. Its banks offered Internet accounts to foreigners, were renowned for their service and provided substantial privacy to clients in a country with very low tax rates. It worked so well that Cyprus' banking industry ballooned to nearly eight times the country's gross domestic product at the height of the boom. In December, it was still more than seven times Cyprus' €17.5 billion GDP. Russians — looking for warmer climes, friendly tax rates and shared culture in the form of Orthodox Christianity — are thought to hold the majority of those, with about €20 billion in the island's banks.

But Cyprus' banks held a lot of Greek debt and suffered significant losses when they took a write-down of those bonds as part of the Greek bailout. Much of Cyprus' bailout money will be used to recapitalize Cypriot banks to prevent them from collapsing. Like other eurozone countries, Cyprus has also seen its deficit and debt explode as growth has ground to a halt. And with the banking system so large, the government wouldn't have been able to bail it out even in a healthy economy.

WHAT WILL THE REACTION BE MONDAY?

Cyprus may be on holiday Monday, but the rest of the world will go back to work. Kirkegaard says that the decision to tap depositors indicates that the European Central Bank is confident that the risk of a bank run elsewhere in the eurozone is low — and by excluding Greek branches of Cypriot banks, they have reduced the possibility even further. Bond markets may react a little since bondholders were also tapped. Bank stocks will probably fall and they'll see their borrowing costs rise since this deal is a signal that other eurozone countries may call on bondholders, if their banks run into trouble.

But Heather Conley, director of Europe program for the Center for Strategic and International Studies, says it's hard to know the far-reaching implications of this one-off deal. The "exceptions" created to solve Europe's debt crisis are adding up, she said. And some investors may look at this late-night, 3-day-weekend deal and see what she saw: a dress rehearsal for a country dropping out of the euro.

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Associated Press Writer Menelaos Hadjicostis contributed to this report from Nicosia, Cyprus.

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