UPDATE 7-Cyprus aims to let small savers off bank tax; veto still likely
* Draft bill spares small savers, veto still seen likely
* Parliamentary debate underway
* Bank levy unlikely to pass - government spokesman
* Cypriot, Russian presidents due to talk
By Michele Kambas and Matt Robinson
NICOSIA, March 19 (Reuters) - Cyprus's government proposed to spare small savers from a divisive levy on bank deposits but said it expected parliament to reject the measure, needed to secure an international rescue and avoid a default that would shake the euro zone.
Parliament began debating the hit on deposits and unless it votes for it EU countries say they will withhold a bailout, plunging one of the smallest European states closer to financial oblivion.
"The feeling I'm having is that the house is going to reject the bill," President Nicos Anastasiades told reporters earlier in the day. Asked why, he added: "Because they feel and they think that it is unjust and it's against the interests of Cyprus at large."
Europe's demand at the weekend that Cyprus break with previous EU practice and impose a levy on bank accounts as part of a 10 billion euro ($13 billion) bailout sparked outrage among Cypriots and unsettled financial markets.
Anastasiades refused to accept a levy of more than 10 percent on deposits above 100,000 euros, which meant taxing smaller accounts too. That hurts ordinary savers with deposits that they thought came with a state guarantee.
Stunned by the backlash and fearing rejection by Cypriot lawmakers, euro zone finance ministers urged Nicosia on Monday to avoid hitting accounts below 100,000 euros, and instead increase the levy on big accounts, which are unprotected by the state deposit guarantee.
The European Union and International Monetary Fund are demanding Cyprus raise 5.8 billion euros from depositors to secure its bailout, needed to rescue its financial sector.
A revised draft bill seen by Reuters would exempt savings under 20,000 euros from the planned 6.75 percent levy on deposits of less than 100,000 euros. The government has not explained how it would fill the funding gap this would create.
French Finance Minister Pierre Moscovici said the euro zone could not lend Cyprus any more, since the country's debt would become unmanageable.
"Above 10 billion euros we are entering into a size of debt that is not sustainable," Moscovici told reporters in Paris.
It was not clear if the vote on the measure would even go ahead in the fractious 56-member parliament, if leaders were sure it would be rejected.
"Whether, when or how the Cypriot parliament will decide I don't know," a senior German official said. "The situation is bad for Cyprus, not because of decisions taken here, but simply because the situation is bad in Cyprus."
International market reaction has been muted so far but if a vote was lost, or postponed for a third time, that could change. The euro was down 0.1 percent on the day, near a three-month low. European shares were flat.
While Brussels has emphasised that the measure is a one-off for a country that accounts for just 0.2 percent of European output, fears have grown that savers in other, larger European countries will take note and be spurred to withdraw funds.
Dutch Finance Minister Jeroen Dijsselbloem, who chairs the group of euro zone finance ministers, said there would be no need to impose a levy in other euro countries.
Deutsche Bank Chief Executive Anshu Jain told a Bundesbank conference in Frankfurt. "We see near term contagion risk as limited. This is unlikely to be a model for other European Union states."
CASH FROM PUTIN?
Hundreds of people waving Cypriot flags protested outside parliament ahead of the planned vote, chanting "People, don't bow your heads!". Police in riot gear cordoned off the street with metal barriers.
"We are here to protest the way Europe is treating us," said Despina Protopapa, 45, who was at the protest with her baby grandson in her arms.
"We were expecting Europe to help and support us but instead they've come to take our money through blackmail," said Protopapa, who works for a Russian offshore company and is worried it will close down.
Tuesday's vote, originally planned for Sunday, has been postponed twice already. Three parties have said outright they will not support the tax, while a fourth, in the governing coalition, said it cannot support it as it stands.
Anastasiades continues to resist raising the levy on big deposits - many held by foreigners including rich Russians - fearing for the island's banking business model and reputation as a safe offshore financial haven.
He asked the EU for more aid during a telephone conversation with German Chancellor Angela Merkel on Monday, with a second call expected on Tuesday.
Some Cypriots hope they could instead get aid from Russia, which has bailed out Cyprus in the past. Many Russians keep their money in Cyprus and operate businesses from there.
Cypriot Finance Minister Michael Sarris was due to hold meetings in Moscow on Wednesday, partly to try to get an extension to an existing 2.5 billion euro loan.
Government spokesman Christos Stylianides said Anastasiades may also speak to President Vladimir Putin, who has described the deposit levy as "unfair, unprofessional and dangerous."
Russia's envoy to the EU likened the levy to a "forceful expropriation" that could wreck Cyprus's financial system.
"When the banks open, people will rush to withdraw their deposits - that's another threat - and then the whole banking system can collapse," said Vladimir Chizov.
Russian authorities have denied rumours that the Kremlin might offer more money, possibly in return for a future stake in Cyprus's large but as yet undeveloped offshore gas reserves, which have raised the island's strategic importance.
An influx of Russian money and influence since the collapse of the Soviet Union has led some Brussels officials to complain privately that Cyprus acts at times as a "Trojan donkey" for Moscow inside the European Union.
Stunned Cypriots emptied cash machines over the weekend and banks are to remain shut on Tuesday and Wednesday to avoid a bank run. The island's stock exchange also suspended trading for another two days.