The big news over the weekend was that European Union officials forced a tax on deposits of 6.75 percent on all bank accounts with amounts less than 100,000 euros and 9.9 percent for accounts above that. There will also be a banking holiday for the next two days on the island. Although Cyprus's economy is a tiny fraction (0.25%) of the European economy, the precedent set from this deposit is catastrophic to the stability of the eurozone. Bank runs within Europe and the collateral damage caused by this will be enough to restore the European debt crisis along with its adverse effect on markets.
More importantly than the actual amount of money seized from the measure is the precedent set by the willingness of Europeans to retroactively tax deposits to protect bondholders. As of the writing of this column, there is still a chance that the Cypriot parliament may soften or reject this levy entirely. However, any reversal of this policy in the near term hardly makes a difference. By even considering the option of direct wealth taxation, Brussels has shattered the confidence of the European banking system.
Why would any depositor risk holding their money in a euro-denominated bank? Interest rates do not offer any real yield and with the high debt levels on sovereign balance sheets and undercapitalized banking systems, there is no reason to assume that any country's bank is safe from deposit confiscation. Individuals' risk of losing 6-10% of savings without notice far outweigh any convenience of a domestic bank account. In addition wealthy individuals can easily move enough money to US dollar, pound, or Swiss franc denominated bank accounts who do not have the same currency contagion risks.
On top of this, Brussels is looking to pass laws that force struggling countries to accept bailouts. If problems with Italy or Spain's banking system persist beyond a point acceptable to German creditors, similar bailout terms to Cyprus can be thrust onto these people without any recourse.
The lack of return on deposits along with the reality of the previously uncharted risk of deposit seizures, a bank run that is starting in Cyprus will spread across the eurozone. Greeks, Spaniards, and Italians who have not already put their money under the mattress will rush to ATMs to pull out remaining cash. These countries have similar risks to their local banks that can trigger similar reactions to Cypriot bondholders. Withdrawals of more deposits will put strain on the capital levels of these banks which adversely affect the solvency of periphery banks. Insolvency of periphery banks will increase credit risk of banks in the core European countries that have loans tied to the periphery, and contagion goes out further from there.
There are also plenty of negative political and economic effects of the Cyprus tax outside of just the banking system. Capital flight from European banks will discourage investment in the eurozone which will have consequences to already contracting European GDPs. The risk of wealth taxes as a condition of staying in the euro will embolden anti-euro sentiment and will make exiting the euro more likely in countries such as Italy where Beppe Grillo was already elected on such a promise. All of this will have collateral damage to the credibility of sovereign debt and the social stability across the eurozone.
Overall, the Cyprus deposit confiscation that took place over the weekend is the definitive trigger of the next round of the European debt crisis. Depositors will quickly lose trust in the safety of their deposits to the point that a bank run will revive anxieties about the viability of the euro. I recommend investors avoid buying European equities or going long the euro (NYSEARCA:FXE). The revival of crisis in Europe is likely enough to end the current rally of an already overvalued US equity market, so it would be wise to take profits (or initiate shorts for those with a higher risk capacity).
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in EWU, EWQ, SPY, IWM over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.