BERLIN -- Fears of renewed economic crisis in Europe flared Monday, as officials took the unprecedented step of targeting bank deposits in Cyprus to help rescue the country's ailing financial system.
The proposal to tax all bank deposits, which requires approval by Cyprus' Parliament, led depositors to empty ATMs over the weekend and raised questions about whether the precedent could upset Europe's banking system more broadly. By taxing all deposits, even those covered by government deposit insurance, the plan slaps at an important presumption of modern banking -- that small accounts in publicly insured institutions are safe.
The proposal upset world markets, led Cyprus to keep its banks shuttered until Thursday while its Parliament debates the deposit tax, and prompted an angry backlash from Russian President Vladimir Putin. Russians have tens of billions of dollars at risk in the island nation -- some of it representing legitimate investment, some of it laundered from illegal enterprises, some of it an effort to avoid Russia's own political uncertainties.
Mr. Putin called the tax "unfair, unprofessional and dangerous" -- unusually sharp opposition by a major power to a bailout program vetted by European leaders and the International Monetary Fund. European officials endorsed the plan at a weekend meeting, and IMF managing director Christine Lagarde said it "appropriately allocates" the costs of bailing out Cypriot banks.
The situation in Cyprus is a potent reminder of how the political economy of the eurozone remains volatile. Though many analysts feel that the worst of Europe's crisis has passed, the prospect of a nation being forced from the currency union remains a possibility and carries an uncertain set of risks.
The United States has little direct exposure to Cyprus. A U.S. Treasury Department statement said officials were watching the situation closely and urged "that Cyprus and its Euro area partners work to resolve the situation in a way that is responsible and fair and ensures financial stability."
World markets dropped modestly Monday, and the euro fell against the dollar, but analysts said the real costs may come later -- if depositors in struggling countries such as Spain and Italy question whether their money is safe in their banks.
Bank depositors have been spared in the eurozone's other bailouts, though other classes of asset holders and investors have suffered officially sanctioned losses -- including owners of Greek government bonds, and bank stockholders in Ireland and Spain. Outside the eurozone, foreign depositors were wiped out in Iceland's 2008 banking crash.
Jacob Funk Kirkegaard, an analyst at the Peterson Institute for International Economics, noted that Cyprus, the IMF and other international creditors had few options. The country's banking problems are so deep that the Cypriot government could not afford the loans needed to fix them. And within Cyprus' banks, deposits are the only pool of money large enough to raise the $7.5 billion that international lenders want Cyprus to contribute to a roughly $20 billion total bailout.
Bank deposits in the country are eight times the size of the economy, and European officials have long felt that low taxes and light regulation in Cyprus have created a money-laundering hub used by affluent Russians. In wealthier European nations such as Germany, Finland and the Netherlands, there is little political support to use their taxpayers' money to protect the accounts of Russian or other outside investors -- particularly given the wide suspicion that some of the money represents the proceeds of illicit activity.
Cyprus is a "special case," Steffen Seibert, spokesman for German Chancellor Angela Merkel, told reporters Monday. It has "no parallels with other countries and, therefore, no impact on them."
Under the proposal, bank deposits of more than 100,000 euros, or about $130,000, would be taxed at 9.9 percent. Deposits under $130,000 would be taxed at 6.75 percent, even though the government of Cyprus had issued deposit guarantees, similar to those from the U.S. Federal Deposit Insurance Corp., up to that level.
Cyprus' banks sustained a heavy hit when they were forced to write off large portions of their loans to Greek banks and holdings of Greek government bonds as part of a bailout for that country last year.
"We are living through the most tragic moments since 1974," when Cyprus was invaded by Turkey, Cypriot President Nicos Anastasiades said late Sunday in an address to the country.
On Monday, Cypriot lawmakers were discussing a new proposal that would lower the burden on smaller depositors and raise it on larger ones. But the damage may have been done.
"I really think it's a disaster," said Clemens Fuest, president of the Center for European Economic Research in Mannheim, Germany, and a top adviser to the German Finance Ministry. "This is quite nasty, and it's quite hard to understand, because it really is a blow to the entire project of a banking union" that the eurozone is trying to create -- in part to ensure that banking woes do not overwhelm national governments.