Could tiny Cyprus trigger collapse of the Eurozone?

It’s being marketed as a one-time tax -- a civic donation to the nation’s financial stability. But the people of Cyprus know it by another name: expropriation.

A government plan to siphon as much as 10% from individual bank deposits to co-finance a bailout went down in flames Tuesday with not a single one of the island’s 56 lawmakers voting in favor.

It’s back to Square One on Wednesday in devising a plan to pony up the $7.5 billion demanded by European central bankers in exchange for $13 billion from Eurozone partners to help Cyprus avert bankruptcy and expulsion from the euro common currency club. Without the bailout, Cypriot President Nicos Anastasiades warns, Cyprus will face “indescribable misery.”

That tiny Cyprus, with fewer than a million people and less than 0.2% of the Eurozone economy, could pose any real threat to the euro’s future would have been laughable a few years ago. But as the currency’s lurch from crisis to crisis continues through a fourth year, economists caution against underestimating the potential damage should Cypriots stand firm on their rejection of conditions for continued Eurozone membership.

Anastasiades is still haggling with Eurozone political leaders in hopes of knocking down the “bail in” figure. Cypriot Finance Minister Michalis Sarris is also sounding out his counterpart in Moscow on extension of a 2011 loan and a push for even deeper investment into the island’s financial welfare.

But economists say they doubt either the “troika” of international finance institutions negotiating a bailout with Cyprus or authorities in Moscow are likely to alter their positions. In that case, Cyprus would then be confronted with a choice of caving in to the deposit tax or facing a life outside the Eurozone.

Time isn’t on the side of the Cypriots. Banks closed Friday and won’t open until the bailout issue is resolved, to prevent a run on deposits. Anger is mounting in the streets of Nicosia, despite Tuesday’s decisive vote, over the very notion of the government seizing personal savings.

“It’s just amazing that we’ve gotten to the point where such a little country is making such big waves. It tells you something about the state of the world,” said Keith Savard, senior managing economist for the Milken Institute in Santa Monica. “I’m not convinced that if Cyprus goes that everything else will be fine, that its departure from the euro will be only an asterisk in history. It’s just not clear that’s the case, and that’s the worry.”

While the $22 billion Cyprus needs to bail out its banks and government finances is “pocket change” at the European Central Bank, Savard said, political considerations like elections in Germany later this year have compelled Eurozone leaders to tighten their fists.

No other troubled Eurozone member has been asked to dip into private bank holdings in exchange for bailout funds. Cyprus likely drew the unusual demand to avoid any appearance of Eurozone taxpayers being asked to compensate Russian oligarchs’ losses. At least a third of Cypriot bank deposits are held by Russians, and some of that $30 billion, though not all, is suspected to be proceeds from corruption or criminal enterprise.

Imposing a graduated levy on bank holdings would have hit the foreign high rollers hardest. As proposed by the government, deposits of less than $26,000 would have been exempt from the levy. Those between $26,000 and $130,000 would have been tapped for 6.75%, and accounts upward of $130,000 would have seen nearly 10% confiscated.

What remained unclear after Tuesday’s vote -- 36 to 0, with 19 abstentions and one absence -- was whether proposals to shift the burden even higher up the economic scale would be successful. Neither is it clear whether Cypriots are willing to abandon their euro membership rather than take the savings hit.

Economists warn that skimming private accounts violates Eurozone deposit guarantees and could spook depositors in other countries with troubled banks. There is also fear that European lenders may raise borrowing rates if they see Cyprus leaving the Eurozone and setting an example for Greece and others to follow.

“I think this represents a dangerous precedent. I would not rule out the possibility that this would be repeated elsewhere,” Uri Dadush, director of the International Economics Program at the Carnegie Endowment for International Peace, said of the deposit tax. “It’s a very, very dangerous course.”

Dadush criticizes what he sees as short-sightedness on the part of Europe’s central bankers in holding back the Cyprus bailout, which has triggered market sell-offs across the continent and an accelerating decline in the euro’s value.

“The reality is that they have saved themselves perhaps 5 or 6 billion euros in loans to Cyprus that they might not have gotten back, but they are now suffering the consequences of hundreds of billions of euros being wiped off the value of equities worldwide,” Dadush said.

Mark Weisbrot, co-director of the Center for Economic and Policy Research, predicted that the “troika” -- the European Commission, the ECB and the International Monetary Fund -- would work out a more acceptable alternative for Cyprus than the deposit tax.

“They’re not going to let the whole Eurozone fall apart over this little bit of money,” Weisbrot said.

He pointed to ECB chief Mario Draghi’s assurances last summer that the bank would do “whatever it takes” to ensure the Eurozone’s integrity.

The Milken Institute’s Savard is less confident about that promise, pointing to the lack of progress on creating a European banking union or holding Eurozone members to commitments to cut deficits and reduce spending.

“If Cyprus does go, this will really force the ECB to do more than say words,” he said. “And I’m not sure they are willing to do this.”

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A foreign correspondent for 25 years, Carol J. Williams traveled to and reported from more than 80 countries in Europe, Asia, the Middle East and Latin America.