Stakes high as Cyprus sweats bank controls

cyprus riots 2
Riot police block students protesting against the terms of Cyprus' bailout

Banks in Cyprus were closed for an 11th day running Tuesday, as officials tried to work out how to reopen them without causing further massive damage to the island's economy and unnerving depositors elsewhere in the eurozone.

Unable to prop up its banks, Cyprus on Monday accepted a 10 billion euro bailout from the European Union. In return, it agreed to raise billions from big depositors in its two main lenders -- Bank of Cyprus and Popular Bank -- and to wind down Popular.

Fear of a bank run prompted the island nation's central bank to drop plans to open some banks Tuesday. Instead, it extended a prolonged bank holiday through Wednesday.

"Teams of technocrats at the central bank and at the Ministry of Finance are working intensively to give the best possible solutions aiming at the speedy normalization of the situation," said government spokesman Christos Stylianides. "And we hope that happens and must happen by Thursday when the banks reopen."

Too few restrictions on transactions when banks reopen, and Cyprus could see its economy implode as money drains away. Too many, and business activity will remain stifled and confidence in other eurozone states could be shaken.

All banks have been shut since March 16 as the government and its European partners wrestled with ways to prevent a financial collapse in the eurozone's third smallest economy. An initial plan, now shelved, called for a levy on all deposits in Cypriot banks -- including those of less than 100,000 euros guaranteed under EU law.

But the damage to the reputation of the banks has been done and Cypriots have been queuing at cash machines, where smaller daily withdrawal limits have been set.

With bank branches shut, many transactions have become impossible, and on Friday the government was granted powers by parliament to introduce much more extensive controls on the movement of money.

Depositors with more than 100,000 euros in Bank of Cyprus and Popular Bank already know they won't get access to their funds any time soon -- they've been frozen as part of the EU deal. They may lose everything at Popular Bank, and be forced to swap 30% to 40% of their deposits for shares at Bank of Cyprus, the country's biggest bank.

Andreas Artemis, chairman of the Bank of Cyprus, and four fellow directors offered to resign Tuesday. A special administrator has been appointed to oversee the bank's restructuring.

Cyprus has pledged to protect all deposits of less than 100,000 euros.

At issue is whether restrictions are applied to small depositors when the big banks open, and the extent to which controls are applied to other banks, which account for 60% of deposits.

Related: Tough times for Cyprus after EU bailout

Cyprus: Bailout hurt European solidarity
Cyprus: Bailout hurt European solidarity

Cyprus was given approval by eurozone finance ministers to introduce controls, provided they are "temporary, proportionate and non-discriminatory."

Finance Minister Michalis Sarris, speaking to the BBC Tuesday, said he was working on a "balanced" package of measures that would apply to all banks for weeks rather than months.

"On the one hand we want the economy to return to as normal a pace as possible, while on the other hand [we're] trying to prevent massive outflows that would be understandable given the protracted period of uncertainty and insecurity," Sarris said.

The economy, already deep in recession, will contract much more rapidly as the banking industry shrinks, deposits are withdrawn and thousands lose their jobs. That will make servicing its debts even harder, perhaps forcing it to seek another bailout.

"We see a risk that this bailout for Cyprus might not have been the last one," said UBS economist Reinhard Cluse.

Fitch said it may cut its credit rating on Cyprus, already deep in junk territory, even further due to the impact of the banking system's failure on the economy and government finances.

Related: Europe: Still a slow-moving train wreck

The imposition of controls will set an unwelcome precedent for the European Union, founded on the principle of free movement of capital and payments. Some economists argue that a partial break-up of the eurozone is already effectively underway, with a euro held in Cyprus no longer worth the same as a euro held in Germany.

Policymakers will have to tread carefully to avoid undermining confidence in other eurozone states, particularly those whose banking sectors, like Cyprus, have large deposits from outside the EU.

"Fearing a similar fate as those with deposits in Cyprus, there is a serious risk that depositors decide to reduce their exposure, putting other countries under stress," noted economists at Nomura, identifying Malta and Estonia as particularly vulnerable.

The Cyprus government said it was setting up an investigative committee to seek "possible criminal, civil and political responsibilities for the great economic tragedy."

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