How the Cypriot meltdown could burn the UK and Europe

Tens of thousands of British savers almost lost part of their savings, but this is just the beginning of Europe's problems.

In what was described as a 'Mediterranean bank robbery', savers in Cyprus-based banks faced losing part of their cash in a one-off 'deposit tax'.

As we reported in What the Cyprus bank crisis means for our money, the levy was agreed by the Cyprus government as part of a bailout deal for the country's deeply troubled banking sector. The bailout is coming from the 'troika' which comprises the EU, the International Monetary Fund and the European Central Bank.

The original levy was set at 6.75% of savings up to €100,000 and almost a tenth (9.9%) of balances above this threshold. Predictably, the announcement has sparked uproar.

The proposal was then revised so that only balances above €20,000 will be raided, sparing hundreds of thousands of smaller savers. However, excluding a large number of savers from this levy means that the eventual tax rate for those with six-figure deposits could be considerably higher than the initial 9.9% proposed. However, the package has been unanimously rejected by the Cypriot Government.

If the impasse continues then Cyprus may default, the island and its banks could enter 'disorderly bankruptcy' and Cyprus could exit the euro. If this happens, then expect all hell to break loose in financial markets. Then again, Cyprus should hold out for a better deal, as its €10 billion bailout is a tiny proportion of the €240 billion Greece has already received in three separate handouts.

10 consumer rights you should know

10 consumer rights you should know

British savers at risk
As things stand today, Cypriot banks are closed until Thursday, so as to freeze deposits and prevent savers – including a large number of rich Russians – from spiriting their money off the island. However, there have been accusations that a few tycoons, oligarchs and money-launderers got wind of these plans and whisked away €2.5 billion before the bank freeze.

According to initial estimates, this one-off bank tax would have hit roughly 25,000 British expatriates currently living or working in Cyprus. In addition, 3,250 members of HM Armed Forces and civilians stationed in Cyprus could be dragged into bailing out their host nation.

With perhaps €2 billion held by Brits in Cypriot banks, the levy could have cost UK citizens at least €135 million. However, with the news that deposits under €20,000 (£16,000) will not be raided, many Brits will dodge this tax grab.

Fortunately, the UK Government has already said that it will compensate service personnel and government workers paying this levy for 'reasonable losses'. Also, savers will receive free shares in Cypriot banks but, given their shaky state, bank shares will surely not make up for savers' upfront losses.

The UK Ministry of Defence has also sent a military plane carrying €1 million to Cyprus to help British troops, civilians and families stationed on the island to pay their bills and buy food. Further shipments are planned as this crisis develops.

What next for Europe?
Since the first Greek bailout in May 2010, I have constantly worried about the stability of the eurozone.

The big problem as I see it is that the troika is trying to force Cyprus to punish its savers purely in order to save bank bondholders. Previously, in major debt restructurings of this kind (and notably in Greece), owners of bank-issued bonds had to share the pain.

Nevertheless, by protecting 100% of the stakes of senior and junior bondholders, the troika has stuck to its guns by not frightening faceless bondholders. Then again, raiding Cypriot savings sends a shot around Europe that customers' savings are simply not safe in ailing economies.

Hence, one unexpected consequence of this deal could be to accelerate cross-border transfers of money out of banks in weaker economies such as the PIIGS (Portugal, Ireland, Italy, Greece and Spain) to safer havens. Personally, I would save only in banks with high credit ratings in stable locations (such as mega-bank HSBC here in the UK, where I keep my cash).

Two small islands: Iceland and Cyprus
This situation very much reminds me of the crisis that left British savers stranded when four major Icelandic banks all spectacularly collapsed in 2008. Savers in British bank Icesave would have lost huge sums, were it not for the UK Government stepping in to guarantee their deposits.

What's more, I would not keep even a single penny in foreign-owned banks operating in the UK. Indeed, were the Cypriot authorities to widen their bank levy to overseas customers of Cypriot banks, it is possible that deposits held in the four UK branches of Laiki Bank could be raided for this tax. Also, deposits up to €100,000 in Laiki Bank UK are protected only by the Cyprus Deposit Protection Scheme, which simply isn't a strong enough safety-net to gamble your savings on.

Furthermore, remember that if the powers-that-be can force one eurozone member to raid savers' cash, then they may do so again. Indeed, what starts off as a one-off tax could become a regular raid as the Cypriot economy continues to limp along. Once confidence in banks in shaken, it is hard to win back.

Finally, British travellers and holidaymakers off to enjoy the Cyprus sun this year should brace themselves for steeply higher prices. With three major taxes – VAT, tobacco duty and alcohol duty and alcohol duty – set to rise locally, expect bigger bills in Cypriot hotels, bars and tavernas!

The five worst financial crises of our time

The five worst financial crises of our time

More stories