If Cyprus cannot agree on a levy on deposits it faces having its biggest banks wound down, which would wipe out uninsured depositors, or could be forced to leave the euro zone, a senior European Union official said on Thursday.
"At the end of the day it is their own choice," said the official, who has direct knowledge of the negotiations between the euro zone, the International Monetary Fund and Cyprus.
"We can do a lot to avoid such fundamental damage that they would have to leave the euro, we and especially the ECB, but if they do not cooperate, they will simply run out of cash and then they would have no other choice but to start printing their own currency," the official said.
The European Central Bank has given Cyprus until Monday to agree on an international bailout or face losing emergency funds for its banks, a move that would almost inevitably lead to the collapse of at least the two largest banks.
"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 official said.
Cyprus, which is cut off from market financing, needs around 17 billion euros in funding, but its parliament this week rejected a bailout because it entailed raising 5.8 billion euros through a one-off levy on deposits.
The levy proposed by euro zone finance ministers and the International Monetary Fund was 6.75 percent on deposits below 100,000 euros and 9.9 percent above that threshold. In theory, euro zone deposits up to 100,000 euros are guaranteed.
Cyprus, where many rich Russians keep money, has rejected the idea of taxing deposits above 100,000, a move President Vladimir Putin called "unfair, unprofessional and dangerous."
NO BAILOUT MEANS WINDING DOWN CYPRIOT BANKS
There is now a stalemate in efforts to get emergency funding for the island, which asked for financial help last June after its banking sector was hit by a Greece's debt restructuring.
Cypriot banks have been shut since Friday and are not expected to open again until Tuesday. If no deal can be reached before Tuesday, there is a risk of a massive withdrawal of funds from Cypriot banks, which could collapse the economy.
The senior euro zone official said the alternative to the proposed levies would be much worse for depositors, with the risk that 30-40 percent of all funds above 100,000 euros would be wiped out, and potentially more than that, especially in the two largest banks, Cyprus Popular Bank and Bank of Cyprus.
The ECB on Thursday gave Cyprus until Monday to find a solution, otherwise it will withdraw emergency assistance to Cyprus, pulling the rug from under the lenders.
"It is difficult to say what would be the exact consequences of resolving the banks but the vast majority of unsecured deposits would be wiped out," the official said.
To handle winding down banks in an orderly way, Cyprus needs to pass legislation on bank resolution, which is ready in draft form. But Cypriot parliamentarians do not want to vote on it yet so as not to make the bank resolution scenario easier.
"They don't want to pass that, because it is a bargaining chip from their point of view. They think they can threaten the euro zone with this, but they are overplaying their hand," the official said.
A law on capital controls, to prevent money flowing out of Cyprus once banks reopen for business on Tuesday, will, however, be passed, the official said.
PENSION FUND NATIONALISATION
As a way out of the fix, the Cypriot parliament could agree to a 12-13 percent levy on deposits higher than 100,000 euros and no tax on smaller savings, the official said. If the island's pension funds were also nationalized, it might be enough to square the circle and finance the bailout.
"The pension funds are cash rich, they are liquid, so you could make a reasonable conversion of cash versus assets in the recapitalized banks," the official said, pointing out that the same solution was used in Portugal, which also needed euro zone emergency funding, and to some extent in Ireland.
Such a move, which could raise around 2 billion euros, would help protect pensioners in case of bankruptcies and the ensuing losses suffered by depositors.
But Germany and some other euro zone countries remain opposed to the idea, the official said.
"There are so many red lines from euro zone countries and from the IMF that it is virtually impossible to have any common territory for the moment," the official said. "There is no flexibility from anybody."
"The German hardliners should start contemplating the pension fund option and the Cypriots have to realize that they have to tax the higher deposits, maybe with a higher rate than 10 percent," the official said.
"The alternative is that all uninsured depositors would lose 30-40 percent in the best scenario of a bail-in."
Cyprus is also seeking five billion euros in a new loan from Russia, on top of a request to extend by five years a 2.5 billion euro loan maturing in 2016.
The official said that while the Russian government has signaled it would not lend new money to Nicosia, Cypriot Finance Minister Michael Sarris, now in Moscow, could be trying to secure new funding from Russian banks or state-owned firms.
Cyprus also has potentially large gas deposits that it could start exploiting from 2018 and is considering scrutinizing future revenues from gas to raise money now. The euro zone official said Russia was unlikely to be interested, however.
(Reporting By Jan Strupczewski; editing by Luke Baker)