Related Story: Cyprus turns to 'Plan B' as Fed plays down crisis

Cyprus has a population of just over 1 million. Its economy represents less than 0.5 per cent of the wider eurozone economy. But the financial crisis in the tiny island nation could have global implications.

Like its near-neighbour Greece, Cyprus is broke. Its banking system is insolvent.

Cyprus has a large banking sector – about five times the size of the nation’s GDP – and its banks had lent heavily abroad.

As the global financial crisis unfolded, Cypriot banks suffered major losses, much of it on Greek government bonds and through exposure to Greek banks.

As a result the Cypriot banking system needs at least 10 billion euros ($12.4bn) in new capital.

The Cypriot state is also in a fiscal crisis. It needs at least 7 to 8 billion euros in additional funds to meet its public debts, or the nation will default.

What triggered the immediate crisis?

Earlier this month the European Union, the International Monetary Fund, and the European Central Bank unveiled a rescue plan that involved a 17 billion euro ($21bn) rescue package for Cypriot banks and the Cypriot state.

As part of the funding for the rescue package, Cyprus was required to impose an unprecedented levy on all bank deposits in the country.

The levy was on a sliding scale, with a 6.75 per cent levy on deposits of less than 100,000 euros in Cypriot banks, and a 9.9 per cent levy on deposits above this amount.

There was an overwhelming public backlash against the levy, which amounted to the confiscation of a share of depositors’ money.

In response, the Cypriot government scrapped the plan, placing the EU-IMF rescue package in doubt.

Why does it matter?

Without a bailout, Cyprus will not be able to meet its international debt obligations and may default on its sovereign debt. Without additional capital, banks in the country are likely to fail. The economy would be shattered, businesses would collapse and Cypriots would probably lose most of their savings.

Since Cyprus is such a small economy, why does this matter to the rest of the world?

There are a number of reasons.

Firstly, overseas banks, particularly in Russia, are believed to have a significant exposure to Cypriot banks. A collapse of the banking sector in Cyprus could cause bank losses offshore, with ripple effects through the wider global financial system.

Secondly, if Cyprus refuses to accept the terms set by the EU and defaults on its debt, it may have to leave the eurozone. There is concern this could spark a domino effect among other, larger heavily indebted nations such as Greece, Italy, Ireland, Portugal and Spain, ultimately forcing the break-up of the eurozone with unpredictable consequences.

Thirdly, a collapse of Cypriot banks and a sovereign default would inevitably flow on to its close neighbour and ally Greece, and may mean that Greece requires a further bailout.

Fourthly, the proposed cure for Cyprus’s woes has become part of the problem.

Undermining trust

The spectre of bank deposits being confiscated as part of bank rescues or debt restructuring has raised fears in Cyprus and other heavily indebted countries such as Portugal, Italy, Ireland, Greece and Spain.

There is concern that it might cause a capital flight, or bank run, in southern Europe — a situation where depositors quickly withdraw their money from the banks, rapidly sending them broke.

Short of a bank run, it may make it more difficult for banks in these countries to raise the new funds they require to stabilise their finances and support lending.

More broadly, the crisis has undermined trust in the European Union, which had previously assured the public that bank deposits would be safe.

It has also renewed doubts about the ability of policymakers in Europe to deal with the ongoing financial woes.

This reinforces the reality that the long process of restoring the finances and economies of Europe will involve pain and loss – though so far, the European Central Bank is steadfastly refusing to accept any losses on the hundreds of millions of euros it has spent to rescue banks and the public finances of nations in crisis.

Map: Map of Cyprus