A weekend announcement that Cyprus would impose a levy on bank accounts as part of a €10 billion bailout by the European Union broke with previous practice that depositors' savings were sacrosanct.
Bank of Cyprus
Euro zone ministers urged Cyprus to let smaller savers escape a levy on bank deposits, before a parliamentary vote on Tuesday that will either secure the island's financial rescue or threaten default.
A weekend announcement that Cyprus would impose a levy on bank accounts as part of a 10 billion euro ($13 billion) bailout by the European Union broke with previous practice that depositors' savings were sacrosanct.
The euro and stock markets fell on concern that developments in tiny Cyprus could reignite the financial crisis in the 17-nation euro zone, while angry Cypriots staged protests outside their heavily guarded parliament.
Before Tuesday's vote, which is too close to call and would send reverberations across the currency area if lost, euro zone finance ministers held an evening teleconference and said depositors with less than 100,000 euros should be protected, officials said.
Under the deal struck in Brussels on Saturday, bank deposits under that level would have faced a levy of 6.7 percent, ripping up the protection savers thought they enjoyed on insured deposits up to that limit, while those above would be stung for 9.9 percent.
The finance ministers said they favoured a higher, 15.6 percent hit for richer savers, so more modest accounts could be spared.
That would look similar to a deal the Cypriots, fearing the destruction of their banking model which lures money from rich Russians and others, baulked at in Brussels at the weekend.
It was not clear if Nicosia will accept it now but if it does, it would still raise 5.8 billion euros from the bank levy as planned, a Greek finance ministry source said. "All Eurogroup ministers said today they wished there was no tax below 100,000 euros but you can't force a country to not do that," the Greek source told Reuters.
"Cyprus doesn't want to impose a large tax above 100,000 because the money will flow out. Two thirds of deposits are from abroad."
The decision to target bank accounts stunned Cypriots, and police sealed off parliament as about 400 people staged a noisy protest outside, aggrieved that their small island of one million people should be singled out for such treatment.
Demonstrators honked horns and waved placards reading "Hang the Banksters, Hands off People's Savings" and "Merkel go home and stay".
Residents emptied cash machines over the weekend and investors feared a precedent had been set that could reignite turmoil in the single currency area that the European Central Bank has calmed in recent months with its pledge to do whatever it takes to save the euro.
The parliamentary speaker said debate on the bank levy would be delayed until 1600 GMT on Tuesday to buy more time to build consensus. Banks, shut on Monday for a bank holiday, will remain closed on Tuesday and Wednesday to avert any panic.
The Greek source said the vote would go ahead on Tuesday as planned.
The euro zone had already indicated changes would be acceptable as long as the return of around six billion euros was maintained. "It is up to the government alone to decide if it wants to change the structure," European Central Bank policymaker Joerg Asmussen, who was pivotal in the weekend negotiations, told reporters in Berlin. "The important thing is that the financial contribution of 5.8 billion euros remains."
On the streets of Nicosia, ordinary Cypriots blamed European leaders, especially German Chancellor Angela Merkel. Protesters had inked the word "No" on the palms of their hands. "Europe is for its people and not for Germany," one placard said.
"They are treating us like guinea pigs," said Takis Georgiou, 49. "The government has lost its credibility in the eyes of the people. We'd be better off leaving the euro and returning to the pound, we don't want to end up like Greece."
On markets, the euro fell before recovering some losses. European stocks dropped two percent before recouping most of the lost ground - denoting only modest levels of concern - with banks taking the heaviest blow.
Approval in Cyprus's 56-member parliament is far from a given: no party has an absolute majority and three parties say outright they will not back the tax. "The most important question is what would happen the following day if the bill isn't voted," Cyprus central bank governor Panicos Demetriades told parliament.
"What would certainly happen is that our two big banks would need to be consolidated. This doesn't mean that they would be completely destroyed. We will aim for this to happen in a completely orderly way."
Brussels has emphasised that the measure is a one-off for a country that accounts for just 0.2 percent of European output.
The worst fear is that savers in other, larger European countries become nervous and start withdrawing funds, although there was no immediate sign of that on Monday. "If I were a saver, certainly in Spain or maybe Italy, I think I'd be looking askance at these measures and think this could yet happen to me," said Peter Dixon, global financial economist at Commerzbank.
U.S. Treasury Secretary Jack Lew, who has talked with his EU counterparts, was monitoring developments closely and expected a "fair" solution, Washington said.
Cyprus's banking sector dwarfs the size of its economy and has been severely hurt by exposure to its much larger neighbour Greece.
Moscow is considering extending an existing 2.5 billion euro loan to help bail the island out and said the fact it had not been consulted about the bailout could come into play. "We will consider the issue of restructuring of the loan taking into account our (future) participation in the coordinated actions with the European Union to help Cyprus," Russian Finance Minister Anton Siluanov told Reuters.
President Vladimir Putin criticised the bank levy as setting a dangerous precedent. "Putin said that such a decision, should it be made, would be unfair, unprofessional and dangerous," Kremlin spokesman Dmitry Peskov told reporters.
Cypriot President Nicos Anastasiades, a conservative elected just three weeks ago, said in a TV address that the tax was an alternative to a disorderly bankruptcy. It was painful, but "will eventually stabilise the economy and lead it to recovery".
But many legislators remain unconvinced. "Essentially parliament is called to legalise a decision to rob depositors blind, against every written and unwritten law," said Yiannakis Omirou, speaker of parliament and head of EDEK, the small Socialist party. "We refuse to subscribe to this."