The debacle in Cyprus has been one of the most interesting and baffling exercises in politicians' logic in recent times. It shows how much politicians are fans of round numbers, regardless of its practicality:
1) Germany said the euro zone should not lend more than EUR10bn to recapitalise Cyprus's banks, even though Cyprus needs about 50% more than that.
2) The IMF didn't want Cyprus's debt to GDP to rise above 100%, even though it's been above 100% for almost its entire time in the EU (and is currently at 140%), effectively defying basic arithmetic.
3) The president of Cyprus was adamant that the tax levied on big depositors (read Russian oligarchs and Greek tax dodgerds) shouldn't be more than 10%, even though it was their fast money coming into Cyprus's banking system which has caused the banking crisis in the first place.
4) Senior bondholders lose nothing, even though depositors are supposed to be paid ahead of bondholders.
The number of Cypriots MPs voting for the bailout package? Zero... Go figure, you mean none of the MPs thought that the four criteria laid out above made sense? What does this all mean? Small depositors take a big hit for a problem that they didn't cause. No wonder people are taking to the streets...I'd riot too if the government tried to do that to me!
Now if you're a Cypriot, things haven't been that bad until now. GDP growth was fairly strong until the financial crisis (see below data from Trading Economics); healthcare, tourism, shipping, and financial services have done well for the country.
Plus, though the country had high debt to GDP ratios historically (why did the EU let them join in the first place with a debt to GDP of 180%?!), it came down dramatically over the past decade until the financial crisis hit and the government had to bail out the banks.
On top of this, the banking problems weren't because of excessive borrowing locally, it was due to foreign deposits coming into the country which the banks then lent back out overseas. Unfortunately, the banks chose Greece as a main destination for a lot of the cash...oops... When the eurozone bailout of Greece forced losses on Greek government debtholders caused austerity which increased non-performing loans, this badly hit the Cypriot banks. So one could view this bailout to be merely an extension of the Greece bailout.
To make it even more ridiculous, the country's central power plant was blown up by an explosion at the naval base next door in 2011. Evidently, the navy didn't think it was a problem stored munitions next to the power plant! So you have to feel for the average Cypriot on the street, who's wondering why they are getting robbed for something they didn't cause.
Now, before you start shedding tears for the Cypriots, they weren't exactly the epitomy of fiscal prudence either. They've run a current account deficits as long as one can remember, i.e. they spend more than they earn. Plus, you have to wonder what they were thinking letting their banking sector get to 13 times the size of their GDP! Well, it's because they made a pretty good living off of all the foreign money which was coming in, even if they didn't realise it.
They also haven't exactly been model citizens of the EU. There's a reason why Russians launder their money through Cyprus...because the country wants them to as long as it gets a cut. They've also backed Russia against the will of the other EU nations...evidently Russia assassinating people using radiation poisoning wasn't enough to make them think about who they should get into bed with. The EU and the United Nations also had an agreement to merge Northern Cyprus, occupied by the Turks since 1974, with the Republic of Cyprus, but Cyprus nixed the deal just to stick it to the Turkish Cypriots. Now Cyprus is giving two fingers to the EU and trying to bargain with Russia in exchange for a naval base and potentially rights to gas fields which haven't been developed yet. So it's not a surprise that the EU wants its pound of flesh from them.
This raises the question, does the EU really need to cave in to Cyprus for a more lenient deal? I agree that it makes no sense to screw small depositors...it would be disastrous for confidence in the financial system if the EU goes back on its EUR 100,000 deposit guarantee. But why not stick it to large depositors? Would taxing Russian money launderers and Greek tax dodgers be a bad thing? It certainly would be poetic justice to hit the people which have benefitted from the lax regulations and tax avoidance of the past two decades.
The ECB is worried about the effect on confidence in other weak Eurozone countries if they don't back Cyprus. But is it really that much of a problem? I don't think so. In a banking crisis, regulators often let some banks go to the wall (either they refused to be helped or are beyond help) but state concretely which banks they will save. As long as the ECB does this, there's no reason why they can't let Cyprus go bankrupt but back other nations. It would certainly give people in say Italy a nice compact example of what happens when you don't take the EU bailout...you leave the Euro currency and suffer a bad devaluation, and you literally will lose half your saving deposits as the banks won't have the money to pay you back since no one is willing to lend to them. It's not a pretty picture, but perhaps letting Cyprus go to the wall if they remain obstinate will give policymakers more credibility that the reforms they are demanding are necessary (though the austerity they are also asking for doesn't make a whole lot of sense right now). Otherwise, the citizens of these countries will keep blaming someone else as the cause of their problems rather than face the reality that they can no longer live beyond their means.
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