Parliament in Cyprus has made a grave mistake. Rejecting the conditions for an aid package from the eurozone and the International Monetary Fund (IMF) will have far-reaching consequences, not only for Cyprus itself, but also for the other 16 members of the euro currency area. The willingness to give the ailing banks and the nearly bankrupt state some 10 billion euros in emergency loans had been a generous offer by the EU and IMF.
But the parliament in Nicosia was under pressure from angry small savers, and subsequently followed an almost absurd logic. Yet, the bailout conditions were not about putting Cyprus under foreign rule, or imposing German interests. It was about keeping Cyprus afloat - the tiny state will be bankrupt by June.
Living beyond their means
The part that the Cypriots themselves would have had to contribute was some 5.8 billion euros and that was an appropriate share. That this amount was to be shouldered by bank clients and investors is an agreement by EU states, including Cyprus.
It is now obvious that the country, for years, has lived beyond its means. The business model to attract foreign capital with low taxes and lax controls on the banking sector went bust last summer. That is when the government in Cyprus asked for international help because the partly state-owned banks were in serious trouble. The national debt was threatening to spiral out of control - and that situation has not changed, despite what at first glance seems like a victory for angry bank customers.
If the eurozone wants to keep Cyprus in the currency union, there has to be urgent negotiations with Nicosia. There is time until June to find a solution when the country will issue it's next batch of government bonds. It is difficult to conceive that eurozone finance ministers over the weekend had such poor judgment about the reaction their offer would cause in Cyprus. Poor management and communication mistakes were made by the EU.
Taxes instead of levy on deposits?
The only option for the Cypriot government now is to get the money in some different way. Instead of a levy on every bank client's deposits, there could be drastic tax increases. But, should Nicosia fail to implement these as well, the country's troubled banks would go bankrupt, leaving small savers to bear losses considerably more significant than the 6 to 10 percent they would have had to pay with a levy.
If banks, and therefore also the state, go bankrupt, Cyprus would have to leave the eurozone. The 800,000 Cypriots would then have to find a new currency and work hard to get on their feet again. A new currency would most likely be dramatically depreciated and would lead to a great deal of money being lost.
Should Cyprus have to leave the eurozone, trust in the currency union on international financial markets would be seriously shaken. The debt crisis in Spain or Italy might also be reignited. Investors' trust in those two countries is already stretched thin.
Faith in Cypriot banks, most likely, is already lost. Starting Thursday (21.03.2013), when the country's banks reopen, private banking customers will try to withdraw their funds in cash from their accounts. That could quickly lead to banks going bankrupt - and it could be contagious. That's why Cyprus is "too big to fail" – even if, compared to other eurozone countries, it is tiny. Eurozone finance ministers now have to come up with a new plan as to how a country that goes bankrupt could exit the currency union.
Should the eurozone try to save Cyprus, no matter what, it would signal to other ailing countries that they do not have to take their reforms and austerity measures all too seriously anymore. That would undermine the entire idea of eurozone bailouts and put the bloc's credibility on the line.
Parliamentarians in Cyprus have stood up to the mighty European Union, but the price they will have to pay for it is hard to gauge. It could be very high - a lot higher than the initial contribution which, after all, l would also have asked foreign bank customers to pay their share. The current celebrations on the streets of Cyprus are unlikely to last very long.