Q&A: Cyprus bailout

The Cypriot government is scrambling to secure a deal to raise the 5.8bn euros it needs to unlock a 10bn-euro bailout from the European Union and the International Monetary Fund (IMF). It has until Monday - the deadline set by the European Central Bank (ECB) which says it will cut crucial funding to Cyprus's banking sector if an agreement is not reached in the Cypriot parliament.

What kind of deal is Cyprus considering?

Earlier in the week, the Cypriot parliament rejected a plan to impose a levy on bank deposits - essentially taking a percentage of bank account balances to help raise the 5.8bn euros it needs. A revised proposal, exempting savers with less than 20,000 euros in their accounts, also appears to have been rejected.

Instead, a number of proposals have been suggested. These include nationalising Cyprus's pension funds, gathering together state assets to support a bond issue, or attracting Russian investment in its offshore gas reserves.

But talks in Russia appear to have ended with no agreement, and the latest plans involve dividing up the second-largest of Cyprus's stricken banks - Cyprus Popular Bank (also known as Laiki Bank) - into a "good" and a "bad" bank.

This would protect deposits of less than 100,000 euros, but potentially allow the government to raid higher deposits to help pay for the bailout.

Any deal needs to meet with approval in the Cypriot parliament as well as the EU, and the Monday deadline set by the ECB means the clock is ticking.

What about Russia?

Russians are believed to hold about 20bn euros in Cypriot bank accounts and their business is hugely important to Cyprus's banking sector. When the bank levy deal was suggested, the Russian government was deeply unhappy that Russian customers would have to pay the levy, and that it was not involved in the bailout discussions.

Since then, there have been suggestions that it would help out Cyprus, possibly by extending a 2.5bn-euro loan it had already made to the island, or by investing directly in its banking sector or possibly its budding natural gas industry.

However, Cyprus's finance minister flew back from Moscow on Friday and the indications are that no deal has been reached.

Was Cyprus not doing quite well before the global financial crisis?

Yes. The International Monetary Fund described the country's economic performance before 2008 as a "long period of high growth, low unemployment, and sound public finances". There was a recession in 2009 but it was the mildest in the eurozone. But two interlinking factors have brought Cyprus close to default - the deteriorating government finances and the country's struggling banks.

So what went wrong?

During the good years Cyprus did build up what the IMF calls "vulnerabilities". There was rapid growth in credit, the banks made many loans to Greece and there was a property market boom.

The banks are central to this story. They grew rapidly. By 2011, the IMF reported that their assets - which include all the loans they have made - were equivalent to 835% of annual national income, or GDP. A chunk of that is down to foreign-owned banks, but those that are Cypriot had made loans to Greek borrowers worth 160% of Cypriot GDP.

There have been losses on the loans to private borrowers because of the depression that has hit the Greek economy. And the value of the debts owed by the Greek government was cut in a debt relief exercise undertaken last year. It might have helped Greece, but the Cypriot banks were hit.

What does that mean for the government finances?

Many countries have rescued their banks in the financial crisis - recapitalising them, in the jargon. It means governments put in money and get shares in return. It is controversial, but governments have taken the view that it is better for the economy than allowing important banks to fail. Cyprus cannot afford the recapitalisation to the extent that the banks need.

The government finances have been further weakened by the slow economic growth and, more recently, decline in the eurozone which have hit Cyprus too. Growing doubts in the financial markets about the government's financial position have made it almost impossible for Cyprus to borrow.

Why was the bank levy considered?

When countries get an international bailout, they are often expected to raise funds themselves, by raising taxes or selling state-owned assets.

The levy on bank deposits was designed to play the same role. It was intended to reduce the size of the bailout and therefore the amount of new debt Cyprus had to take on. But there is almost certainly a political aspect, too. In the eurozone, there are concerns about money-laundering in Cyprus and the presence of large amounts of Russian-owned money in the banks. Germany is reputed to be especially unhappy about the idea of using European taxpayers' money to rescue them.

Experts say the decision to target ordinary savers came about because Cypriot banks have fewer private bondholders than banks in other eurozone countries. In the Greek bailout, it was private bondholders who had to take a "haircut" - a slice out of their investment.

After the deal provoked outrage in Cyprus, the parliament promptly voted against it, and it is being increasingly seen as a blunder by European and Cypriot authorities.

Didn't savers think they were protected?

To a degree, yes they did. The point is, the banks have not collapsed. This deal is aimed at saving them from collapse. Had they done so, then savers would have had their first 100,000 euros (£86,000) protected under the Cyprus Deposit Protection Scheme - assuming the scheme could have paid out all this compensation.

Are the UK operations of Cypriot banks affected?

Bank of Cyprus UK says it is not directly affected by events in Cyprus itself. Although it is a subsidiary of Bank of Cyprus, it is a separately incorporated UK bank and depositors are protected by the UK's Financial Services Compensation Scheme (FSCS), which covers savings up to £85,000. Laiki Bank, which has four branches in Britain, says it is currently operating normally and does not expect UK account holders to have to pay any levy imposed by the Cypriot government. However, because the UK operations are directly controlled from Cyprus, they do NOT come under the FSCS. Protection of up to 100,000 euros is instead provided by the Cyprus Deposit Protection Scheme, which relies on backing from the Cypriot government.

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