LONDON (Reuters) - The surprise decision by euro zone leaders to part-fund a bailout of Cyprus by taxing bank deposits sent shockwaves through financial markets on Monday, with shares and the bonds of struggling euro zone governments tumbling.
The bloc struck a deal on Saturday to hand Cyprus rescue loans worth 10 billion euros ($13 billion), but defied warnings - including from the European Central Bank - and imposed a levy that would see those with cash in the island's banks lose between 6.75 and 9.9 percent of their money.
Parliament in Cyprus put off a vote on the measure - which has shaken depositors' confidence in banks across the continent - until Tuesday, however, and with public anger at the deal widespread the government said it was already looking to ease the pain for small savers.
Without the rescue, Cyprus would have be unable to avoid a default. That would have undermined the promise that Greece's debt writedown last year was a one-off, but the unprecedented move to hit depositors adds a radical new dimension to the crisis across the euro zone.
The initial response of investors was unambiguous. Shares lurched lower, the euro fell to a new three-month low, while safe-haven assets such as gold and German government bonds jumped.
The cost of insuring the debt of even high-quality European banks against default also rose sharply with analysts citing fears the decision could spark contagion across peripheral regions with the potential for widespread outflows of deposits.
"If I were a saver, certainly in Spain or maybe Italy, I think I'd be looking askance at these measures and think this could yet happen to me," Peter Dixon, global financial economist at Commerzbank said.
The European Markit iTraxx senior financials index, which tracks the most important European bank credit default swap (CDS) rates, widened by 17 basis points.
Some credit default swaps in Spanish, Italian and Portuguese banks widened more sharply with the five-year CDS for Spain's Santander 30 basis points higher, while for Italy's UniCredit it was 23.5 basis points wider.
However, some in the markets were drawing support from a view that the safety measures put in place at the European Central Bank should contain the fallout.
"Clearly this is a negative development for European assets but in the terms of contagion we think it is quite limited," said Guillermo Felices, head euro asset allocation at Barclays in London.
"There are tools - such as the ECB's OMT (bond buying program) and the option of more 3-year LTROs (ECB loans to banks) that can provide liquidity if needed - that the market will feel comfortable about when assessing the longer-term implications."
Three of the world's biggest central banks are also expected to signal their fresh commitment to loose monetary policies this week.
The Bank of Japan welcomes a new governor on Wednesday who is likely to begin pumping huge amounts of yen into the recession-hit economy. On the same day the Bank of England may get a new pro-growth mandate in the British government's annual budget, while the Federal Reserve is expected to reaffirm its commitment to the current aggressive U.S. bond-buying program.
Equity markets were underscoring the more immediate worries, however, that the Cyprus deal could see savers and firms in other highly indebted countries like Italy and Spain rush to pull money out of their own banks.
By 1115 GMT the pan-European FTSEurofirst 300 <.FTEU3> had clawed back around half of its initial losses but was still down 0.8 percent in its worst morning since last month's inconclusive Italian election.
London's FTSE 100 <.FTSE>, Frankfurt's DAX <.GDAXI> and Paris's CAC-40 <.FCHI> were down 0.8, 1 and 1.4 percent respectively, leaving MSCI's global share index <.MIWD00000PUS> down 0.85 percent.
CENTRAL BANK SUPPORT
In the currency market, the euro staged a slight recovery after having dropped as low as $1.2882 in the Asian trade, to session be up 0.1 percent on the day $1.2950.
The dollar <.DXY> itself, which investors often head for when tensions in Europe rise, gained 0.45 percent.
"Euro zone politicians will be at pains today to manage down the danger of contagion to other markets. The euro will find a little bit of support from that but markets will remain jittery," said Jane Foley, senior currency strategist at Rabobank.
Italian and Spanish bond yields both jumped sharply as the two countries remain at the centre of concern in the euro zone due to the size of their economies which some economists warn would be too big to rescue.
If savers and firms did pull their money en masse from already strained banks it could tip the region back into full-blown crisis, although the ECB's backstop measures are designed to prevent such problems.
The widespread anxiety drove up German government bonds, the traditional favorite of risk-adverse European investors, and indiscriminately pushed up the cost of insuring against a sovereign default in the euro zone's southern rim.
German Bund futures were up 49 basis points at 144.09 by late-morning in Europe, while gold, another safe-haven asset, rising to a 2-1/2-week high of $1,608.30 an ounce before settling at $1,601.60, up 0.6 percent.
U.S. crude and Brent oil both tumbled, with Brent futures $1.70 a barrel lower at $108.12 before recovering a little to trade around $108.20 by 1030 GMT. U.S. oil declined $1.10 to $92.35.
(Additional reporting by Richard Hubbard and Nia Williams. Editing by Peter Graff and Alastair Macdonald)
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