Media including Reuters and German newspaper Welt am Sonntag reported last night that a deal had been reached to apply a 20 percent levy on deposits over 100,000 euros at Bank of Cyprus Pcl, the country’s biggest lender, and a four percent tax on deposits of that size at other banks.A 20% deposit levy means if you had 100,000 euros on deposit a week ago that when the banks re-open there will be 80,000 in your account. The government is taking 20% to raise enough money to qualify for a bail out from the ECB.
The Cyprus banks have been closed for over a week now and have even limited the amount available for withdraw from ATMs. http://www.zerohedge.com/news/2013-03-24/cyprus-laiki-bank-lowers-atm-withdrawal-limit-%E2%82%AC100 It is not clear when banks will re-open. There are reports that gas stations in Cyprus are shutting down because they do not have cash to pay for deliveries and customer do not have cash to pay for filling their tanks. Interestingly, petrol seems to be a cash business in Cyprus. Of course extending credit in the current situation would be risky.
Cyprus needs a bail out from the ECB in order to avoid defaulting on the bank's bonds and their government bonds. If Cyprus defaults bond holders would get about 80 cents on the dollar*. Defaulting would be a shock to the Cyprus economy because many businesses, institutions, and savings and pension plans are likely heavily invested in these bonds. In addition the Cyprus government would have to dramatically reduce spending because they would no longer be able to borrow to finance deficit spending and revenue would drop due to the slower economy.
If Cyprus defaulted they would likely be kicked out of the Eurozone and need to create a new currency, or use another currency such as the USD. The default that leads to an exit would hurt the people of Cyprus. Leaving the Eurozone would not necessarily be bad for the average citizen of Cyprus. Iceland took the path of default and seems to have recovered nicely. However, Iceland had its own currency, the Krona so Cyprus is blazing new ground.
The ECB does not want Cyprus and its banks to default because many European countries own its bonds. Cyprus is using this leverage to its full advantage and trying to negotiate better terms. As the saying goes "if you borrow $1M from the bank, the bank owns you; if you borrow $100B you own the bank".
The ECB is demanding that Cyprus raise 5.8B euros of the total financial need of 17B euros. Presumably the ECB bail out is to loan Cyprus the difference. A loan will keep their banks and government solvent for the short term. Long term structural problems (e.g government spending) will still need to be addressed.
Cyprus annual GDP is 18B euro. Cyprus bank assets of 128B euro are so large compared to GDP because Cyprus is a banking haven for eastern European oligarchs. Russian companies and individuals have an estimate 31B euros of wealth in Cyprus.
Several years ago large, off shore natural gas fields were discovered at Cyprus. Conspiracy theorists suggest that the ECB is motivated to keep Cyprus in the Eurozone and indebted to gain control of these resources.
*my estimate of 80 cents on the dollar is based on reported total Cyprus bank assets of 128B Euros and total financial need of 17B euros rounded down.