Cyprus bailout seen shrinking due to tax on deposits

BRUSSELS Fri Mar 15, 2013 12:40pm EDT

European Union (EU) and Cypriot flags flutter atop the Presidential palace in Nicosia February 22, 2013. REUTERS/Yorgos Karahalis

European Union (EU) and Cypriot flags flutter atop the Presidential palace in Nicosia February 22, 2013.

Credit: Reuters/Yorgos Karahalis

BRUSSELS (Reuters) - International lenders are aiming to give Cyprus a bailout of close to 10 billion euros, less than initially expected, with taxes imposed on Cypriot bank depositors likely to fill the gap, officials said on Friday.

Euro zone finance ministers meet at 12:00 p.m. EDT along with IMF chief Christine Lagarde to discuss the bailout, mainly needed to recapitalize the Mediterranean island's banks which were hit hard by a sovereign debt restructuring in Greece last year.

The ministers might not reach a final decision on Friday, officials said, because of the complexity of the issues including the possible involvement of Russia, which has strong business ties with Cyprus.

"We're going to take stock of the situation in Cyprus, hear from the institutions ... we will see how far we will get," the chairman of euro zone finance ministers Jeroen Dijsselbloem said on entering the meeting.

The package is likely to contain a mixture of tax increases, one-off revenue raising measures, plans for privatizations and an overhaul of the banking sector to ensure Cypriot debt is sustainable and Nicosia can pay back what it borrows.

Russia could help finance the program by extending a 2.5 billion euro loan already made to Cyprus by five years to 2021 and potentially reducing the interest rate, which is now at 4.5 percent, officials have said.

Germany's Chancellor, Angela Merkel, underscored the priority that was being given to solving the country's problems at a news conference after a meeting of European Union leaders.

"To leave Cyprus up to its own devices and simply see what happens would not be responsible, in my view," Merkel said.

Cyprus, with gross domestic product of barely 0.2 percent of the bloc's overall output, applied for financial aid last June, but negotiations were stalled by presidential elections in February.

Without emergency lending, Cyprus will default and threaten to shatter the return of investor confidence in euro zone public finances fostered by the European Central Bank's promise to do whatever it takes to shore up the currency bloc.

RANGE OF TAXES

Cyprus originally estimated that it needed about 17 billion euros - almost the size of its entire annual output - to restore its economy to health. Up to 10 billion euros of that were earmarked to recapitalize its banks and 7 billion required for servicing debt and running general government operations.

But because a loan of that magnitude would increase its debt to unsustainably high levels and call into question its ability ever to pay it back, policymakers sought to reduce it by finding more revenue sources in Cyprus itself.

Talks this week already cut the bailout to a range of 10-13 billion euros, which was in turn narrowed down to the lower end in preparatory talks among technical experts on Friday.

"The Cypriot bailout will be close to 10 billion euros in total," one euro zone official with insight into the negotiations ahead of the ministerial meeting said.

For a final agreement, the International Monetary Fund, the European Commission and European Central Bank need to present a report on the state of Cyprus' banking sector, its economy and possible solutions.

One official said a report had been delivered by the troika but orally, not in writing.

Cypriot Finance Minister Michael Sarris will travel to Moscow for meetings on Monday, Cypriot diplomats said, raising the possibility that an agreement on participation can be struck with the Russians that would be included in a final deal.

The IMF has pushed the idea that depositors in Cypriot banks should bear some of the costs of bailing out the island, a process dubbed "bail-in". But that approach is rejected by Cyprus, the European Commission and some members of the ECB.

In the preparatory talks ahead of the ministerial meeting, the idea of bailing-in depositors lost support because it would be legally difficult and carry the risk of weakening confidence in banks across the euro zone, officials said.

Instead, support grew for imposing taxes on those holding money in Cypriot banks. A tax on the total sum of depositors of 5 percent, for example, or a tax of 20-30 percent on interest generated by the deposits would not threaten financial stability, officials said.

Cyprus is also likely to raise its nominal corporate tax rate and sell off state assets.

Plans are already being made for another meeting of euro zone finance ministers next week, once the Cypriot finance minister has returned from Moscow and a more precise idea of the shape of the rescue deal has been formed.

(Additional reporting by Robin Emmott, John O'Donnell and Luke Baker. Editing by Mike Peacock)