Although that unwise scheme was later rescinded, much damage was done to a country already deep in financial crisis. Instead of a generalised deposit tax, uninsured deposits of the islands two large troubled lenders suffered big haircuts. Meanwhile, capital controls were imposed.
These restrictions were supposed to be a short-term measure, not that this ever seemed likely. A year on, the most important controlspreventing people or companies taking more than small sums of money out of the countryare still in place and depressing the economy's animal spirits.
Cyprus bears most of the blame for its predicament. But the euro zone is also to blame, as it connived in the deposit grab idea and went along with other bad decisions too. It should now offer a helping hand, especially by enabling the lifting of capital controls.
The good news is that the Cypriot economy shrank only 5.4% last year. The troikathe European Commission, the European Central Bank and the International Monetary Fundhad initially projected a drop of nearly 9%.
There are three main reasons for the relatively good performance. First, tourismespecially from Russiahas held up well.
Second, the Cypriot economy is flexible. This has meant that companies have mostly been free to cut wages and survive, points out Fiona Mullen of Sapienta Economics, a local consultancy.
Third, domestic consumption has fallen less than expected. This may be because most ordinary people were not hit by the deposit haircut after it was restricted to accounts larger than 100,000 euros. They have also dipped into their savings.
However, all is not well. One concern is that the Crimean crisis may have a knock-on effect on Cyprusif economic problems in Russia or
visa restrictions imposed by the West cut the flow of tourists.
But even without worrying about Russia, there are problems closer to home. For a start, investment has collapsed. The IMF forecasts that it will end this year 60% below its 2008 peak.
Some of the decline is healthy: Cyprus had engaged in a real estate binge. But the drop-off in investment in machinery means the country is not building for its future.
Part of the explanation is that companies are loaded up with debt. Whats more, they cant get access to new finance because local banks are themselves up to their eyeballs in bad debts. Total private-sector debt is nearly 300% of GDPand, under a stress scenario by Pimco, the asset management firm, 60% of this borrowing could turn sour.
The high debt means that both companies and consumers will have to tighten their belts. The IMF says that to get borrowing to a sustainable level, companies will have to cut debt by the equivalent of 45% of GDP while households will have to slash it by 55% of GDP. This will be a drag on the economy, which the IMF expect to shrink another 4.8% this year.
There are two things the euro zone should do to help. First, it should enable Cyprus to lift capital controls. It is easy to understand why this hasnt happened: the troika is worried that people will rush to take their money abroad. The banks would then run out of cash, unless the ECB was willing to authorise the Cypriot central bank to inject liquidity.
While this fear is understandable, there could be imaginative ways round the problem. One, suggested by Mario Zachariadis, a member of the countrys national economic council, would be to lift the controls but at the same time impose a large tax, of say 35%, on capital exports. The government could then say it intended to reduce the tax over time, eventually to zero.
The advantage of such a scheme is that, if there wasnt much capital flight, after a couple of months the tax could be cut to say 30%. Meanwhile, the prospect of the tax coming down over time would mean that depositors would have less incentive to run immediately.
There would, of course, still be a risk, which the national central bank and ECB would ultimately have to underwrite. But it would be worth taking.
The second way of helping Cyprus would be to create a bad bank to take over the bad loans that are infecting the banking system. Such a scheme has been deployed successfully in two other euro zone crisis countries, Spain and Ireland.
The advantage is two-fold. Freed of its bad loans, the banking system could focus on financing healthy companies. Meanwhile, the bad bank could operate like an investorconverting debt into equity when borrowers have viable operations, or shutting them down when they dont.
The IMF and the ECB normally like bad banks following crises. The snag is that somebody needs to finance themand the euro zone doesn't seem keen to commit more money than the 9 billion euros it is already lending the country.
Cyprus may be small enough to forget about, but it is also small enough to help. It has been virtually a model pupil since it came under the troikas tutelage. Now it should be rewarded.
The author is editor-at-large, Reuters News