Eurozone finance ministers and the International Monetary Fund (IMF) agreed on a 10bn euro-rescue loan package for Cyprus on Saturday morning, a decision intended to save the country from default and recapitalise its banking sector.
The bailout had initially been valued at €17.5bn, €10bn for bank recapitalisations and €7.5bn to prevent the country's default. However, that amount was nearly the entire annual output of Cyprus' economy and was considered impossible to pay back on top of public debt that is already above 90% of gross domestic product (GDP).
In an interesting turn of events, bank depositors will have to share in the burden in order to make up the difference. Cyprus will impose a one-time tax of 9.9% on deposits above €100,000 and 6.5% on smaller deposits. Those amounts will be frozen on customer accounts in order to assure payment once banks re-open on Tuesday March 19th following a bank holiday. The tax will allow Cyprus to raise around €6.0bn.
Depositors will be compensated by equity in the banks. There will also be a tax on the interests generated by deposits.
In return for the rescue loans, Cyprus has also agreed to trim its deficit, shrink its banking sector, raise taxes, and privatise state assets, said Eurogroup President Jeroen Dijsselbloem.
Additionally, Cyprus agreed to increase its nominal corporate tax rate from 10% to 12.5%.
Under the programme, the country's public debt is expected to be capped at 100% of GDP by 2020.
Although the Cypriot economy represents a tiny part of the Eurozone, the bailout was still considered crucial because of a possible fallout in the broader region that could upset financial markets and hurt investor confidence.
The decision to impose losses on depositors has caught most people by surprise with some analysts predicting that it will set a precedent for future bailout packages. Until now, taxpayers faced most of the burden while some losses were imposed on shareholders and junior debt holders.
Fears of the potential contagion to the Eurozone banking system have increased, including the possibility of bank runs in weaker members.
"The decision to impose losses on depositors signals euro-area policymakers' willingness to risk triggering wider financial market disruptions in pursuit of other policy goals," said Bart Oosterveld and Alastair Wilson in an analysts' note for Moody's Investors Service.
"While raising the risk of deposit flight out of peripheral banking systems, the agreement reflects euro-area policymakers' desire to avoid sovereign defaults in addition to Greece's."
The currency markets re-opened on Sunday night with capital flowing into safe-haven currencies.
The euro gapped lower versus the US dollar
from Friday's closing price of $1.3073 to $1.2905. The euro opened lower versus the Japanese yen, also a safe-haven, at ¥1.2170 from Friday's close of ¥1.2454.
The euro weakened against the sterling pound from £0.8649 to £0.8532 and against the Swiss franc, down from CHF1.2270 to CHF1.2178.
The euro remained down around 2.0% versus the yen and almost 2.0% versus other currencies on Monday morning, although it trimmed some of the earlier losses.
"It will take a while before risk-on sentiment will return," said Shuichi Kanehira, head of FX spot trading at Mizuho Corporate Bank.