NICOSIA (Reuters) - Cyprus is expected to make a dramatic U-turn on Saturday to avert the imminent threat of financial meltdown, having signalled it is willing to tax big savers in its stricken banks to clinch a bailout from the European Union.
The island's partners in the 17-nation euro zone scheduled a meeting for Sunday in Brussels, in a strong sign they believe a solution is near.
As hundreds of demonstrators faced off with riot police outside parliament late into Friday night, lawmakers inside voted to nationalise pension funds, pool state assets for a bond issue and peel good assets from bad in stricken banks.
Officials said a deal was imminent to raise 5.8 billion euros demanded by the EU in return for a 10 billion euro lifeline, including some kind of levy on bank deposits, which could be voted on as soon as Saturday.
Without a deal by Monday, the European Central Bank has threatened to cut off cash for Cypriot banks, spelling certain collapse and possible ejection from the euro.
Cyprus moved perilously close to bankruptcy when its parliament threw out the proposed levy on Tuesday, with Cypriots enraged by plans to hit small holdings of ordinary savers as well as large accounts, many held by foreign investors.
In the absence of the bank levy, Nicosia turned to Russia, whose citizens have billions of euros at stake in Cyprus's outsized banking sector. But Finance Minister Michael Sarris returned from Moscow empty-handed. On Friday he said the bank levy was back "on the table".
Party officials told Reuters that discussions were centred on a levy on depositors holding over 100,000 euros, sparing smaller savers. One official said the tax could be limited to big savers at the island's biggest lender, Bank of Cyprus BOC.CY, at a 20 percent rate.
Lawmakers adopted a bill that would pave the way for the government to split its failing lenders into good and bad banks. The measure is likely to target Bank of Cyprus and No. 2 lender Cyprus Popular Bank CPBC.CY, also known as Laiki, and would make it easier for the government to safeguard deposits that enjoy a state guarantee of up to 100,000 euros.
"With the process of consolidation, the depositors over 100,000 euros will wait for several years to see how much of their deposits they will collect," said Averof Neophytou, deputy leader of the ruling Democratic Rally party.
"At the same time, this political decision to support this harsh law safeguards 100 percent of the deposits of 361,000 depositors in Laiki Bank," he added, referring to depositors with up to 100,000 euros.
In Finland, an ally of Germany in disciplining euro zone partners, European affairs minister Alexander Stubb told Reuters he was confident Cyprus would accept EU rescue terms "because there are no other options".
The pace of the unfolding drama has stunned Cypriots, who barely a month ago elected conservative President Nicos Anastasiades on a mandate to secure a bailout.
But lawmakers balked at hitting small savers with the bank levy, a rejection of the kind of strict austerity signed up to by Portugal, Ireland, Greece, Spain and Italy over the last three years of Europe's debt crisis.
Germany warned Cyprus it was "playing with fire". Moody's downgraded its credit rating on deposits in Cypriot banks to Caa3, just two rungs from the bottom on its 11-grade scale of junk debt.
The EU says the only way to find the 5.8 billion euros Cyprus needs to contribute to the bailout of its banks is from the depositors who put money in them.
The tottering banks hold 68 billion euros in deposits, including 38 billion in accounts of more than 100,000 euros - enormous sums for an island of 1.1 million people which could never sustain such a big financial system on its own. Much of the banks' capital was wiped out by investments in Greece.
Many of the biggest depositors are foreigners, including rich Russians, and European politicians are loathe to spend taxpayers' money on a bailout if the depositors take no losses.
With banks in Cyprus closed until Tuesday, Cypriots have been besieging bank cash machines all week. Faced with an almost certain run on banks when they reopen, parliament also gave the government the power to impose capital controls.
"Our so-called friends and partners sold us out," said Marios Panayides, 65, a protester at the parliament. "They have completely abandoned us on the edge of an abyss."
Retailers, facing cash-on-delivery demands from suppliers, warned stocks were running low.
"At the moment, supplies will last another two or three days," said Adamos Hadijadamou, head of Cyprus's Association of Supermarkets. "We'll have a problem if this is not resolved by next week."
The Bank of Cyprus urged the government to go back and cut a deal with the EU under which larger deposits over 100,000 euros would be taxed. It was preferable, it said, to a collapse of the system and ejection from the euro which would wipe out assets.
"There must be no further delay," the bank said.
Taking a first step toward financial consolidation, Cyprus arranged on Friday for the takeover of big Greek units of its two biggest banks by a Greek competitor.
EU officials criticise Cyprus for initially insisting any deposit levy should hit even small savers. Cypriot leaders did not want to shift the whole burden to bigger depositors in the apparent hope of saving Cyprus's offshore banking industry.
German Chancellor Angela Merkel told lawmakers that while she wanted to keep Cyprus in the euro zone, it must first recognise it had no future as an offshore financial centre, two parliamentarians told Reuters.
Her finance minister, Wolfgang Schaeuble, said that muted reactions to the crisis in financial markets showed the euro zone was able to contain the Cyprus problem.
The Dutch head of the euro zone finance ministers' group, Jeroen Dijsselbloem, said the group wanted to keep Cyprus in the currency union. But when asked, he did not rule out an exit.
"All kinds of scenarios are possible and the scenarios we're focusing on are to come to a joint solution in which Cyprus is saved but in which the banking sector continues in a smaller but healthier form."
Additional reporting by Jan Strupczewski and Luke Baker in Brussels, Karolina Tagaris and Costas Pitas in Nicosia, Georgina Prodhan in Vienna, Lidia Kelly and Darya Korsunskaya in Moscow, Paul Carrel in Frankfurt and Gernot Heller in Berlin; Writing by Matt Robinson; Editing by Peter Graff