Bailout Strains European Ties

Cyprus Deal Preserves Euro but Sows Mistrust Between Continent's Haves, Have-Nots

A deal reached Monday in Brussels may have saved Cyprus from becoming the first country to crash out of the euro, but it came at the cost of widening the political mistrust between the strong economies of Europe's north and the weaklings of the south.

By GABRIELE STEINHAUSER , MARCUS WALKER,MATINA STEVIS 

Several officials familiar with talks in Nicosia and Brussels over the €10 billion ($13 billion) rescue for the island described more than a week of chaotic negotiations. European officials cited Cypriot foot-dragging, reversals and dropped communications, a situation one European Union official called "terrifying." Cypriot officials described their European opposites as demanding and inflexible.

The fresh bitterness over the Cyprus mess—which appears deeper than at similar points during Greece's extended financial turmoil—could hamper future attempts to fix the bloc's flaws. Germany, the euro zone's biggest economy, prevailed as it typically has in the negotiations, but at the price of growing resentment over what some Europeans saw as its bullying of a tiny nation.

The accord will see big depositors and other creditors lose large sums following the radical downsizing of the country's biggest bank and the shuttering of its second largest—the first time such a "bail-in" has been seen in the three-year euro-zone crisis.

On Monday, Cypriots waited nervously for banks to reopen after their March 15 closure, wondering whether there would be further deposit flight. The country's central bank said late in the day that all of the country's lenders would remain closed until Thursday, after saying earlier that all but the two largest would reopen Tuesday.

Markets greeted the deal with an optimism that quickly faded when Dutch finance minister Jeroen Dijsselbloem suggested in an interview that big bank depositors and senior creditors may be expected to contribute to future euro-zone bailout packages. Later, after bank shares and other euro-based assets fell on the remarks, he appeared to backtrack in a message from his Twitter account: "Cyprus [is a] specific case. Programmes tailor-made to situation, no models or templates used."

The Dow Jones Industrial Average also fell after the remarks, closing down 64.28 points to 14447.75 on Monday.

Monday's agreement capped a 10-day psychological drama. Cyprus's president struck an initial deal that would have seen the country raise its share of the bailout funds byrequiring all account-holders in Cypriot banks to pay a tax on their deposits, only to see the plan struck down by parliament. Cyprus went hat-in-hand to Moscow for help, to no avail. Cyprus also raised eyebrows in euro-zone central banks by allowing several hundred million euros to be wired out of the country in the past week, despite an official freeze on outflows on all but a few exempt categories, such as funds for humanitarian purposes.

On Thursday morning, the European Central Bank threatened to cut off liquidity to Cypriot banks—condemning them to instant bankruptcy—if no deal was reached by Monday.

By Sunday, officials said negotiations were close to breaking down on several occasions. "Nobody wanted to take the decision that could have led to the first exit of a euro member," said one official following the negotiations. "But it could have been the consequence."

The final accord will see depositors with less than €100,000 in their accounts at Cyprus's two largest banks keep all their money. Bigger depositors in the banks are set to pay a sharply higher price. Large account-holders at Cyprus Popular Bank, the second-largest bank, will have deposits converted into shares in a "bad bank" to contain poor-quality assets, and will likely be repaid only a fraction of their savings over time.

In the end, this deal ended up looking like a more severe version of an early proposal floated by Germany and the International Monetary Fund to close the country's two biggest banks—a plan that had been rejected by Cypriot president Nicos Anastasiades 10 days earlier.

At that time, Mr. Anastasiades instead agreed to a plan to levy a tax on all account holders in Cypriot banks—a proposal that was quickly perceived as a mistake by German Chancellor Angela Merkel and others because it penalized small savers.

After Cyprus's parliament rejected a version of the levy on Tuesday, officials from Germany and other creditor countries grew irritated as they waited to hear Cyprus's promised "Plan B."

Cypriot finance minister Michael Sarris—in Moscow for what turned out to be a fruitless request for funding—wasn't returning calls from his euro-zone peers. Meanwhile, in Nicosia, negotiators from the IMF, European Central Bank and European Commission spent up to 16 hours a day holed up in the glass-front Central Bank building. Seldom did Cypriot officials show up to join them, according to European officials.

Struggling to collect information from the ground, Brussels-based officials relied on media reports to get a sense of what the Cypriot government was planning.

"It's difficult to disentangle from the Cypriots who is proposing what," said a senior euro-zone official. "I have never, ever witnessed anything like this. It's a disaster."

A Cypriot official countered that Nicosia had put several proposals on the table in an attempt to contain the fallout on the economy and society. "The troika were the ones coming with more and more demands," this official said. "They had a clear mandate not to move from their positions. The issue was political, beyond economic rationale."

The fight over the future of Bank of Cyprus, the country's largest lender, became heated by Thursday. Officials in Brussels and in Cyprus noted that many Cypriot parliamentarians keep their savings there.

Mr. Anastasiades tried to sway Ms. Merkel, asking her by phone for a more lenient deal, said people familiar with the call. The chancellor told him that she wouldn't haggle over specifics and that Cyprus needed to talk to the troika.

On Friday morning, Ms. Merkel's patience was running out. She angrily briefed lawmakers from her ruling center-right coalition and told them Cyprus was trying to face Europe down, according to people present. Cypriot leaders haven't understood yet that their "business model" of outsize offshore banking has failed, she said. Europe had to stick to its principles, she added: Aid is only for countries that were prepared to reform, she said.

Ms. Merkel told her advisers and lawmakers she didn't want to see Cyprus leave the euro zone. But the chancellor and her finance minister prepared to let Cyprus fail if it wouldn't agree to terms, German officials say.

Tensions were running high Sunday in Brussels as key officials—including IMF chief Christine Lagarde, ECB head Mario Draghi, EU President Herman Van Rompuy and other top EU officials—met Mr. Anastasiades over a lunch of lamb and baby potatoes.

Mr. Anastasiades complained that his country was being treated more harshly than any of the euro zone's other bailout victims. He backtracked on an earlier agreement to wind down Cyprus Popular Bank.

According to a senior Cypriot official, Mr. Anastasiades was appalled by the way he was spoken to at the lunch. The president threatened to resign. Mr. Dijsselbloem told him he didn't care about the president's political future, only the future of the euro zone, the senior official said.

The lunch ended two or three hours later "and not in a good mood," said a second official.

Meanwhile, troika technical experts went to work in the European Council's headquarters in Brussels on a new proposal for Cyprus: Wind down Cyprus Popular Bank and fold its good assets into Bank of Cyprus. But most euro-zone finance ministers summoned to the building to sign off on the deal were forced to wait in their national delegation rooms on the seventh floor.

Germany's Finance Minister Wolfgang Schäuble grew particularly irascible, officials said. At one point, Ms. Lagarde went to calm him down. She also tried to raise spirits in Mr. Van Rompuy's fifth-floor suite, where top EU officials were meeting with Mr. Anastasiades. The IMF chief handed out M&Ms, as officials say she often does at late-night European negotiations.

As EU leaders tried to calm Mr. Anastasiades and convince him to accept the need for radical surgery to Cypriot banks, his finance minister, Mr. Sarris, was negotiating an eight-point action list in another room with EU Commissioner Olli Rehn, ECB executive-board member Jörg Asmussen and Austrian official Thomas Wieser, who chairs the euro zone's regular consultations among finance officials, according to people familiar with the meeting. The "annex" that the four men drafted outlined the specifics of dealing with the top two Cypriot banks.

As the evening dragged on, Mr. Schäuble and French Finance Minister Pierre Moscovici consulted their respective leaders by phone. Then they conveyed a Franco-German message to the Cypriot leader: Mr. Anastasiades should give up hope that a summit of euro-zone leaders would lead to an easier deal. Even if a summit were to be called, the deal facing Cyprus would be the same one as now.

Shortly before midnight, the Cypriot president came back with a new proposal, which officials said backtracked on the closure of Cyprus Popular. At that point, the EU leaders calmly told Mr. Anastasiades "to pack up and leave" if he wasn't ready to cooperate, one official present at the meeting said.

The president signed off on the broad deal—one more costly than the one its parliamentarians rejected last week.

"There is no doubt in the government that the first deal was far better," said a senior Cypriot official. "We bluffed and we lost. The whole thing was a fiasco."