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How can they do that?! A look at Cyprus' decision to seize a part of bank deposits

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PARIS - Lawmakers in Cyprus are still scrambling for a way to raise €5.8 billion ($7.5 billion) to help pay for an international bailout of the country's banks and government.

A plan to seize up to 10 per cent of people's savings has been met with fury and it has raised concern, if not panic, in the rest of Europe about the security of bank deposits in times of financial turmoil.

On Tuesday, Cypriot lawmakers are scheduled to vote on a revised plan that would not be so burdensome for people with less than €100,000 in the bank. Any plan must be approved by the other eurozone countries, which would then commit €10 billion in rescue loans to Cyprus.

Banks in Cyprus will remain shut until Thursday to give political leaders time to hash out a deal.

Here's a look at the plan and the problems it may pose.

HEY, HOW CAN THEY DO THAT?

As a member of the euro currency, Cyprus can raise or lower taxes whenever it wants. It isn't the first time that a eurozone nation has raised taxes to cope with mounting debt and to prop up struggling banks. Residents of Greece, Portugal and Ireland — all bailout recipients — have seen their tax bills skyrocket in recent years 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 IT WORK?

Banks have already acted to seal off the amount of the levy — a 6.75 per cent tax on deposits under €100,000 and 9.9 per cent on those above — so depositors can't access it. Banks will remain closed until Thursday to avoid a rush of withdrawals while lawmakers finalize the move. They will vote on Tuesday, but some are seeking modifications, mainly to lower the tax rate on deposits under €100,000. To do that, however, they have to raise the rate for the larger depositors, since the overall scheme has to raise a total of €5.8 billion.

HAS THIS EVER HAPPENED BEFORE?

So far in the euro crisis, depositors have been protected. But European countries have taxed bank deposits before. In the 1990s, Italy levied a tax on every bank account to stave off the collapse of its lire currency. The rate, however, was miniscule — 0.06 per cent — 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: Cypriot banks are overwhelmingly funded by deposits, not bondholders. So it wouldn't have been very fruitful to go after bondholders.

WHO IS AFFECTED?

All people with money in Cypriot banks — except those with money 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 more than €68 billion on deposit in Cypriot banks, foreigners hold about 40 per cent — 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, said Jacob Kirkegaard, senior fellow at the Peterson Institute for International Economics in Washington. That is because many Russians have dual citizenship and many Russian businesses are registered on the island. Kirkegaard 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 centre, much the way Ireland and Iceland before it did. Its banks offered Internet accounts to foreigners, were renowned for their service, provided substantial privacy to clients and had very low taxes. 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, lower tax rates and shared culture in the form of Orthodox Christianity — are thought to hold the majority of those accounts, 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 writedown 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.

WHY DO RUSSIANS KEEP SO MUCH MONEY IN CYPRUS?

Russian businessmen have preferred to place their savings in offshore jurisdictions, partly to escape political uncertainty and corruption in Russia. Cyprus offers a 10 per cent corporate tax rate and relatively stable political situation. Cyprus is also believed to be a top destination for money-laundering. It is much safer for a corrupt Russian official to keep proceeds from illegal activities abroad, hiding information about their fortunes and holdings away from the prying eyes of Russian banking regulators. Russian officials estimated that about $49 billion, which is equivalent to 2.5 per cent of Russia's gross domestic product, was wired to foreign accounts illegally last year.

WHAT HAS THE MARKET REACTION BEEN?

Stock markets and the euro dropped on Monday but not too much. 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.

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, three-day-weekend deal and see what she saw: a dress rehearsal for a country dropping out of the euro.

___

AP writer Menelaos Hadjicostis contributed to this report from Nicosia, Cyprus.

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