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Why did Cyprus rattle Canadian markets?

Cyprus, a small island country in the Eastern Mediterranean Sea, showed the world on Monday that while it may be tiny, it is mighty when it comes rattling global equity, currency and bond markets. Reports over the weekend that Cyprus would impose a tax on bank deposits as part of a 10 billion euro ($13 billion) bailout by the European Union caused quite the stir.

The big and negative surprise hinged on the bank levy, and Canada was not immune to the broader market mood and reaction as investors worried the idea could spread.

If a country with gross domestic product of some $22 billion, or 0.2 per cent of the overall euro zone economy, can do it why can't others, was the key question on the minds of market players.

A mad dash to withdraw money from banks would threaten the so-called stability of any banking system, which is why the prospect resulted in an early bout of "risk aversion," a market term that often means people are wary and dumping "riskier" assets in favor of safe havens like the U.S. dollar and Treasuries.

Bank deposits are the core foundation of any banking system, which relies on them to then provide credit. If deposits dry up, then bank lending dries up.

"The ability to provide credit is the oil that fires any economic engine," said Craig Fehr, Canadian market strategist for Edward Jones in St. Louis.

"If you see a massive run on bank deposits ... then that banking system as a whole, in a very short amount of time, can undergo a massive change where banks don't have money to lend."

Camilla Sutton, chief currency strategist at Scotiabank, said the headline caught people off guard.

"Most don't expect a levy to be filed against bank deposits. It does set a precedent going forward that this is a potential not just in Cyprus, but some of the other euro regions that would be vulnerable," she said.

The proposed deal could mean a tax on depositors in Cyprus. So far, large deposits in excess of 100,000 euros would lose 9.9 per cent, while the government is slated to take 6.75 per cent from small depositors. This is expected to raise 5.8 billion euros, wrote Marc Chandler, global head of currency strategy and Brown Brothers Harriman.

The debate on the bank levy is expected to continue on Tuesday.

Like others, Fehr stressed he doesn't expect a bank run scenario to play out, and noted global markets had calmed down by early afternoon on Monday.

But given the global nature of markets it comes as no surprise news around the globe would hit Toronto stocks or the Canadian currency, he said.

"It's a reflection of the fact that markets are far more global than they used to be," he said.

"The interconnectivity of bond markets and stock markets continue to increase. That's a trend we expect to progress over time. What happens half way around the world, can matter, in our markets back home in Canada."