Cyprus -- The Nightmare Scenario
The Cypriot banks did what all banks do. They gambled. They borrowed money by taking in deposits as well as selling bonds, promised to repay, and then invested in assets they were sure would pay off. These assets included lots and lots of Greek government bonds.
Unfortunately, it’s three options are a rock, a hard place, and another rock. The first is reversing its decision of a couple days back and accepting the IMF/EU conditions for a bailout, namely imposing a 9.9 percent haircut on deposits over €100,000 and a 6.75 percent haircut on smaller deposits. The Russians hate this and the public hates it even more. The second is telling the IMF/EU to get lost, reopening the banks, and watching crazed depositors rush to get whatever money they can out of the banks on a first-come, first-serve basis. The third is going off the euro and declaring that all deposits will be paid off in new Cypriot pounds, which the government will simply print out of thin air.