Cypriot bailout tax could have unintended casualty: trust in Europe's banks

Europe continued to struggle Tuesday to explain a controversial plan to bail out the troubled Cypriot economy, one that is undermining the continent’s most prized – but scarce – asset: trust.

The Eurogroup, which brings together the finance ministers of the 17-member eurozone, disclosed Saturday a 10 billion euro ($13 billion) rescue package for Cyprus that requires the fiscal haven island to raise another 5.8 billion euros from its banks by taxing depositors.

However, the loan agreement with the troika – the European Union, the International Monetary Fund, and the European Central Bank – unexpectedly included a controversial levy of 6.75 percent on bank deposits below the 100,000 euro ($130,000) benchmark, the maximum amount that accounts are insured for in Europe.

Europe tried to rectify the plan, and on Monday and Tuesday EU and Cypriot officials insisted that while they would not negotiate how much money Cyprus needed to raise, the country could choose to tax only the rich. The initial package contemplates a 9.9 percent tax for accounts over 100,000 euros, but small depositors could be exempt all together by increasing the upper bracket to 15.6 percent.

The concern is not over doomsday-scenario bank runs, as it’s clear that the EU can manage the Cypriot economic meltdown. But at the very least, the EU raised serious doubts about its promise to guarantee citizens’ savings – a vital pillar of any financial sector that underpins savers’ trust – when it went along with a plan to levy small Cypriot depositors.

Cyprus directly blamed German Chancellor Angela Merkel for the tax. Germany and the ECB said it was a Cypriot decision. Whatever the case, European leaders have systematically insisted since Saturday Cyprus is an exception, not applicable to any other country. And indeed, the EU also announced over the weekend that the bailout terms for Ireland and Portugal would be loosened.

Still, Europe set a precedent that raises the question – one specifically worrisome for Spaniards and Italians – of whether any future financial aid could bring along with it similar provisions targeting bank deposits.

The Cypriot government has yet to muster enough support to approve the bailout, delaying the parliamentary vote planned for today. Currently, the government is pushing to decrease the burden on small accounts while leaving the tax rate unchanged for large ones, which the Central Bank said would fall short of revenue.

Awaiting the outcome, the cost of borrowing continued to increase in Europe, especially in Spain and Italy, while stock markets and the euro exchange rate continued their declines.

An exception?

The Cypriot government doesn’t want to increase taxes on rich account holders too much because non-residents – especially from Russia – hold as much as half of the country’s deposits and would likely withdraw much of their funds, weakening the broader financial system.

Europe’s decision to tax depositors, though, intentionally targets foreign depositors, especially from Russia. Cyprus is a Russian fiscal paradise, paying high return rates, and is believed to be a laundering hub for Russian oligarchs.

Russian President Vladimir Putin condemned the Eurogroup’s decision and the country said it could review the terms of a 2.5 billion euro ($3.2 billion) bailout it already gave to Cyprus, which could also upend the island’s economy.

But northern Europeans – more critically, German voters who will decide later this year whether to reelect Chancellor Merkel – don’t want to give Cyprus and its Russian depositors a free-ride.