Cypriot crisis puts EU on dangerous ground

The week began with sketchy details of a Cypriot bailout trickling out of Brussels in the early hours of Saturday. It ended with chaos and anger on the streets of Cypriot capital Nicosia.

The stakes in Cyprus 's bailout crisis increased dramatically yesterday as the countrymoved dangerously close to economic collapse. With Cyprus having bluntly rejected the euro zone's bailout plan on Tuesday, this time it was Eu rope's turn to call the shots. Yesterday, Cyprus's international lenders rejected the country's Plan B, or rather parts of it. The suite of measures scrabbled together to raise the €5.8 billion in place of a tax on deposits included a plan to raise funds through the nationalisation of semi-state pensions and a dramatic restructuring of the banking sector. This would see the country's second biggest bank, Laika, split into good and bad banks, which would probably protect deposits of less than €100,000 at the expense of larger depositors.

Behind closed doors in Nicosia, and through phone calls throughout the day, Cyprus's lenders made it clear this was unacceptable. In Germany, chancellor Angela Merkel was more specific, openly voicing opposition to the proposal to nationalise pension funds. The rejection sent negotiators back to the drawing board.

Turning point
It was clear from Thursday morning, when the Europe an Central Bank threatened to cut off funding for Cyprus's banks, that Europe was back in control of a chaotic situation. The intervention was a turning point: the ECB does not normally do public ultimatums – even with Ireland and Greece, any alleged pressure was exerted in private.

Its failure to get a deal from Russia left Cyprus looking foolish and desperate and altered the deadlock's power dynamics, despite the diplomatic language used by prime minister Dmitry Medvedev yesterday in a press conference with European Commission president José Manuel Barroso. With the possibility of a Russian rescue off the table, the determination of the EU and International Monetary Fund to bail-in larger depositors, many of whom they suspect to be Russian money-launderers, is likely to be reignited. Last night a deal to tax depositors appeared to be back on the table.

All this has been taking place against the background of a paralysed banking system. Cyprus's banks have remained shut since last weekend and customers have been denied access to their funds, with banks introducing a limit on ATM withdrawals on Thursday. Capital control legislation that will give the Cypriot finance minister and central bank governor power to control the transfer and withdrawal of money has been drawn up to guard against a bank run on Tuesday.

The spectre of Cyprus's banks collapsing is now a viable threat and a development that would probably force the country out of the euro zone. The ECB is the key player here. As with Ireland, where the overdependence of Irish banks on emergency liquidity assistance (ELA) funding was one of the triggers for the Irish bailout, the ECB's provision of ELA will dictate in the short term if the banking system survives. The rules of ELA are not clear-cut – technically the ECB could decide to withhold liquidity assistance at its next governing council meeting next Thursday – but the imposition of Monday as a deadline seems to suggest the ECB will let Cypriot banks go if it is pushed.

Confirmation that Greek bank Piraeus is buying the Greek-based units of Bank of Cyprus and Laiki yesterday confirmed the worst fears of Cypriot depositors, who fear the euro zone is prepared to let Cypriot banks sink.

But despite the prevailing sense in Nicosia of betrayal at being abandoned by its European partners, Europe is treading on dangerous ground. The fear of contagion is foremost in euro-zone authorities' minds, with fears centring on possible knock-on effects on already shaky economies, particularly that of Spain.