Cyprus: Why the world needs to care

Short of a civil insurrection, with lots of tear gas and truncheons for the cameras, it’s not easy for an island of a million people to capture the headlines or global markets. However, Cyprus is giving it a go this week as it follows Iceland and Ireland over a fiscal cliff.

Why should we care? Barring a bailout of $22-billion, this tiny Mediterranean outpost’s banks will go bust, the country will likely default on its debt, all of which will send a new shock wave through the eurozone and could serve as the final nail in the coffin for the teetering economies of Portugal and Greece.

The challenge, as so often in these situations, is that the past is murky and the future looks lousy. How Cyprus’ two biggest banks got themselves to the edge of implosion can be traced largely to its ties to Russian money -- it's reported nearly a third of all money in Cyprus banks is Russian -- a source of lucre falling somewhere between the Hells Angels and the Vatican in the realm of trust funds.

Lured by its high interest rates and penchant for looking the other way, Cyprus is now one of the world’s top offshore stashes of cash. Russian dollars in Cypriot accounts are now believed to top 25 billion euros ($33 billion in Canadian dollars).

As the bankers and lawyers of Bermuda and the Cayman Islands will tell you, being an offshore banking economy has its many perks. But when things sour – i.e. colossally big and bad loans to Greece go sideways - and the subject of a bailout emerges, foreign dollars tend to skedaddle fast, lest they be used to sop up the mess around them.

And that’s exactly what was proposed by the European Union and IMF: A deposit tax that was designed to raise 5.6 billion euros for government coffers; an unwavering demand from the EU in order for Cyprus to secure a 10-billion euro bailout. The target? Any account of more 100,000 euro would be dinged, while smaller savers (those accounts under 20,000 euros) would be spared.

Naturally, that didn’t go over well in either Nicosia, Cyprus’ capital city, or in Moscow, home to much of the ill-gotten gains in the first place. The story from there is the standard one. Riots in the streets and indignations uttered from afar. Russian president Vladimir Putin denounced the tax as “unfair, unprofessional and dangerous." (Matters of which he's intimately familiar)

And then, of course, the banks were shut, before the funds could flee for good. Today, Cyprus’ fiscal affairs are in tatters, and its reputation as a safe place to stash cash is irrevocably impaired.

The heat is now on the Cypriot government to figure out an alternative to the deposit tax, or see its banks implode, likely tossing Cyprus’ presence in the euro zone out in the process. The danger then becomes what a Cypriot default and banking collapse would mean for fellow European economies, all now so closely intertwined. While Cyprus may be an isolated case, a default would surely unravel investor confidence and send global market spiraling.

The European Central Bank has given governors in Nicosia until Monday to decide what they are going to do.