Cyprus’s proposed deposit grab is a bad precedent. Money had to be found to prevent its financial system from collapsing. But imposing a 6.75 percent tax on insured deposits is a type of legalized robbery. Cyprus should instead impose a bigger tax of on uninsured deposits and not touch small savers.

Confiscating savers’ money will knock confidence in the banks. Trust in the government will also take a hit, since Nicosia had theoretically guaranteed all deposits to a level of €100,000, or about $130,000. Small savers should be encouraged, not penalized. Those who squirrel away their savings are the quiet heroes of the financial system, not those who drag it down by engaging in borrowing binges.

Nicosia has not technically broken its promise to guarantee small deposits. That is because it is not the banks that are failing to repay savers — something that would have set off the insurance program. Instead, it is the government itself grabbing a slice of deposits. The pill is also being sugared by giving savers shares in the banks as compensation. That said, the mechanism is still an effective breach of promise.

There is no denying that Cyprus needed a solution. The small Mediterranean island was on the brink. Its banking system — which had grown to eight times its gross domestic product on inflows of Russian money and aggressive expansion in Greece — was technically bust. Its exposure to the Greek economy, Greek government debt and Cyprus’s own burst property bubble had seen to that.

Nicosia’s euro zone partners made it clear that there was no time to waste. They had chosen to hold their finance ministers’ meeting Friday night, knowing that Cyprus already had a bank holiday scheduled Monday. The country’s president said the European Central Bank was threatening to cut off liquidity Tuesday if there was no deal. The banking system would have collapsed.

In total, Cyprus requires €17 billion — almost 100 percent of G.D.P. — to rescue its banks and deal with the government’s own bills. If Nicosia had borrowed all that cash on top of its existing debt, it would have been carrying an unsustainable burden. It would have been only a matter of time before the debt needed restructuring.

Cyprus’ euro zone partners and the International Monetary Fund rightly decided not to lend it so much money, limiting the bailout to €10 billion. This means Nicosia should end up with debt equal to a manageable 100 percent of G.D.P. in 2020.

The problem was where to find the extra €7 billion. Because Germany and other northern European countries were not prepared to give a handout, there were two options: force the government’s own bondholders to take a loss, or hit bank creditors.

The option of a haircut on government debt — as Greece imposed last year — was rejected. Many of the bonds are held by Cypriot banks, so a haircut — a loss on investment — would just have increased the size of the holes in their balance sheets, meaning they would have needed an even bigger bailout. The Cypriot government’s credit would have been destroyed for little benefit.

So, pretty much by default, the banks’ creditors had to be tapped. Ideally, bank bondholders would have taken the strain. But Cypriot banks have hardly any bonds. So there was not much money that could be grabbed there.

This, incidentally, rams home the importance of requiring all banks to have fat capital cushions, consisting either of equity or bonds that can be bailed in during a crisis. The sooner international regulators come up with a minimum standard for so-called “bail-in” debt, the better.

Given that Cypriot banks did not have such a cushion, the remaining option was to hit depositors, for €5.8 billion in total. There was even some rough justice in the policy. After all, as much as half of the country’s €68 billion in deposits is held by Russians and Ukrainians, and some of this money is thought to be black money laundered through Cyprus.

What is more, the country’s banks have been paying high interest rates in recent months — in some cases of as much as 7 percent on euro deposits. That is clearly danger money. Depositors should have known there were risks attached to such high rewards.

If the deposit tax had been confined to uninsured deposits, which are facing a 9.9 percent levy, such arguments would have merit. But the insured savers have also been hit with a 6.75 percent tax. It would be better to get the money entirely from the €38 billion of uninsured depositors. That would require raising the tax to about 15 percent. It is still not too late for Cyprus’s Parliament to change course.

The Cypriot government did not want to do this, because uninsured deposits are disproportionately foreign and it was feared that such a high tax would undermine its status as an offshore financial center. Even if there is domestic political logic in cushioning Russian mafia at the expense of Cypriot widows, such a policy is bad for the rest of the euro zone.

There probably will not be any immediate contagion to other crisis countries from Cyprus. After all, banking systems in Greece, Spain, Portugal and Ireland have recently been recapitalized. Meanwhile, the combination of Cyprus’s relatively huge banking sector and the fact that it is perhaps small enough to experiment with make it a special case.

Even so, citizens in the rest of the euro zone now know that if push comes to shove, their insured deposits could be grabbed too.

Hugo Dixon is editor at large of Reuters News.

Article source: http://www.nytimes.com/2013/03/18/business/global/18iht-dixon18.html?partner=rss&emc=rss