Published March 21, 2013
BRUSSELS – The European Union has given Cyprus until the close of business on Monday to come up with a plan to raise nearly 6 billion euros and secure an international bailout.
Without it, the European Central Bank has said it will cut off emergency liquidity assistance (ELA) to the island's main banks.
That could prompt the collapse of the economy, which relies on banking, finance and tourism. Banks have been closed and will not open again until Tuesday, by which time a plan needs to be agreed.
Following is a look at what may happen in the days ahead.
BANKS REOPEN AFTER BAILOUT DEAL
If the government does not extend the bank holidays, Cyprus's main retail banks - Bank of Cyprus, Cyprus Popular Bank, Hellenic Bank and USB Bank - will open for business on Tuesday morning.
If a deal has been reached with the European Union and IMF, the chances are disaster can be avoided.
There is likely to be heavy withdrawal of funds, particularly from international depositors, but the ECB would be able to go on providing ELA, a backstop that will keep the banks standing. If markets react positively to that and a sense of calm returns, funds could even eventually flow back.
That is a best-case scenario and even then, restructuring of the banks would still be required.
BANKS REOPEN WITH NO BAILOUT AGREEMENT
If an acceptable deal has not been reached with the EU and IMF by late Monday and the bank holiday is not extended, a grimmer outcome is likely.
Banks may open their doors but may just as quickly have to close them in the face of a stampede to withdraw funds, particularly at branches of Cyprus Popular Bank and the Bank of Cyprus, the two largest and worst affected of the island's lenders.
The banks could stay shut for longer but with Cypriots already confined to taking money out of ATMS the chances of social unrest willl grow if they do not reopen soon.
Either option is academic. Without ECB support, the banks would not be viable and would collapse.
If it becomes clear between now and Monday that no agreement is going to be possible with the EU and IMF, then it is probable that the Cypriot parliament will approve legislation imposing capital controls on financial institutions.
A law has been submitted to parliament.
That might go some way to limiting the immediate outflow of deposits, which before the crisis stood at around 70 billion euros.
But it wouldn't do anything to bolster the solvency of the banks, particularly the two worst-affected institutions.
GOOD BANK/BAD BANK
A senior EU official said on Thursday it may be necessary to force the creation of a "good" bank and a "bad" bank.
In a best-case scenario, the good bank would be left holding all performing loans and insured deposits, that is accounts with less than 100,000 euros in them. The bad bank would house all non-performing loans and accounts with more than 100,000 euros in them - those not protected by a deposit guarantee.
The EU official said deposits in the bad bank would have to be "haircut" by 30-40 percent - far more than under the bank levy proposed by the euro zone as part of a bailout.
Even deposits up to 100,000 euros, in theory guaranteed by the Cypriot government, could not be paid out in full, because the island has no funds to back up its deposit guarantee.
And even if a rescue plan is agreed and the ECB goes on providing emergency assistance, a bank may have to shut down given the lack of trust in the sector.
Cyprus's central bank said on Thursday its second largest lender, Cyprus Popular Bank, would be restructured to avoid bankruptcy.
The collapse of the banking system would leave the economy paralyzed and in chaos over the short-term.
Further out, the best route to recovery would require a significantly devalued currency. The only way to engineer that would be to leave the single currency, which Cyprus joined in 2008.
"If the financial sector collapses, then they simply have to face a very significant devaluation and faced with that situation, they would have no other way but to start having their own currency," the euro zone official told Reuters.
Some euro zone policymakers have said, however, that it would be preferable to deal with a bankrupt country within the euro zone, not outside it.
So the prospects for Cyprus without a bailout are bleak but why does the euro zone seem prepared to let it go? With Greece, the fear of a domino effect was so acute that it was drawn back from the brink.
Greece may be a small part of the currency bloc - about two percent of its GDP - but Cyprus is 10 times smaller. Policymakers believe they can make the case that with a banking system eight times larger than the size of the economy and awash with foreign money, it is a one-off case that would never be replicated elsewhere.
If people got edgy about banks elsewhere in the euro zone, the ECB could flood the system with liquidity until confidence was restored. As such, policymakers believe the threat of contagion is limited.
(Writing by Luke Baker and Jan Strupczewski, editing by Mike Peacock)