Cyprus must agree to deposit levy otherwise financial aid will be withdrawn.

Will investors keep their money in Cyprus? Or will they trigger a banking collapse and the first ejection from the euro? And if the Mediterranean island goes bust, what are the risks? Could there be a run on banks and stocks that could overwhelm bigger economies, as the once-mighty European single currency becomes treated as a busted flush?

These questions, larded with risks for the half a billion people in the European Union, are the result of a drastic toughening of the EU's debt-crisis strategy, unleashing a crazy week of down-to-the-wire haggling.

Over five years, the eurozone and the International Monetary Fund have forked out loans of €85 billion ($132 billion) to bail out Ireland, €100 billion for Spain and, in two doses, a total of €230 billion to save Greece.

But it is over a relatively measly sum for Cyprus, which accounts for just a fraction of 1 per cent of the EU's economy, that these deep-pocketed lenders have now spat the dummy.


Breaking with precedent, they called for deposits in Cypriot banks to be taxed so that the pain of bailing out its economic rescue was shared fairly. By raising €5.8 billion, Cyprus would unlock the emergency loans of €10 billion. Under this scheme, Cyprus would slap a levy of 6.75 per cent on deposits of less than €100,000, and 9.9 per cent for more than that threshold.

But no sooner had freshly-elected President Nicos Anastasiades reluctantly agreed to the deal than he was disavowed by the Cypriot Parliament. Protesters outside cursed Germany, the EU's paymaster, as a money-grubbing tyrant - and Russia, whose businessmen account for a huge chunk of savings in this shady tax haven, said the tax was a non-starter.

So it was time for Plan B. And, bitter and frustrated, the European Central Bank, the guardian of last resort in the 17 economies of the eurozone, unveiled its thermonuclear bomb.

It issued a bleak two-sentence communique that, if there was no deal between Cyprus and the IMF and EU by today, it would withdraw the liquidity that has kept the country's two largest banks afloat.

With this, Cypriots stared into the abyss of a banking collapse: a future where no one could withdraw their savings, where businesses would insist on cash payments for goods and purchases, followed by likely ejection from the euro as debts fell due. Pleas for a last-minute lifeline from Russia, a close ally, fell on deaf ears.

Banks there have been ordered to remain closed until tomorrow, many businesses are refusing to accept transactions by credit card and withdrawals from cash machines have been limited to prevent a catastrophic withdrawal of money.

As the clock ticked loudly, MPs frantically approved a series of bills, creating "good" and "bad" banks out of assets held by the Laiki bank - a move that will mean large depositors will have their money there blocked for years. They also approved controls to prevent a flight of capital, and set up a "solidarity fund," including pensions, aimed at luring new capital. And back on the table, too, was the much-hated levy on deposits to provide the €5.8 billion demanded by international lenders. Media reports, in a situation fluctuating almost hourly, say the Government has decided on a 20 per cent levy on savings over and above €100,000 at the country's main lender, the Bank of Cyprus, and 4 per cent on deposits over the same amount at other banks. That should provide the €5.8 billion demanded by international lenders. The stakes are highest for Russians. Moody's says they have US$70 billion, or about 4 per cent of Russia's gross domestic product, tied up in Cyprus.

With his public still digesting these changes, Anastasiades was to head to Brussels today, hoping for the green light from eurozone ministers, the IMF and the ECB before market trading and the reopening of banks.

Beneath the extraordinary tale of U-turns, back-biting and confusion is the political situation in Germany, where Chancellor Angela Merkel faces elections this year, says Nicolas Veron of the Breugel Institute think-tank.

"Merkel's main opposition, the SPD, has identified the Cypriot issue earlier this year as a wedge issue on which it could destabilise her," Veron believes. "The SPD calculation was to paint Ms Merkel as too lenient with shady Russian oligarchs and their 'black money' held in Cypriot banks, while she would be prevented from responding because this would be too destabilising for Europe's financial system. In effect, Ms Merkel called the SPD's bluff by risking the Eurozone's first bank run."

Germany's gamble is that Cyprus is so small that if it becomes insolvent, the risk of contagion to other sickly economies would be limited.

The gain would be a stiff message to other profligate "Club Med" countries to get their finances into line.

"The crisis over Cyprus has so far had no measurable impact on the [borrowing] rates of, for example, Spain or Portugal," German Finance Minister Wolfgang Schaeuble told the daily Bild. "The financial markets clearly recognise that the eurozone is essentially better prepared for possible turbulence."

Some experts believe that the greater challenge lies beyond Cyprus. "The real test of this tough stance strategy will not be the next week. The real question is whether the Eurogroup can maintain its tough stance in case bigger countries will get into trouble and apply for financial support," said Nicolaus Heinen of Deutsche Bank in Frankfurt.

Once more, a financial crisis that Europe thought it had doused last year by opening the monetary spigots has flared again, stoking doubts about the design of its 14-year-old monetary union. "The Cypriot crisis demonstrates once again that the biggest challenges to the future of the euro are political rather than economic - specifically, getting national parliaments and the public to support deals hammered out over their heads by the EU, IMF and ECB," said Pawel Swidlicki of the Open Europe think-tank.