Market rally as Cyprus braces for a bitter pill

Global markets have rallied after European leaders struck a last-minute deal to prevent a meltdown in the Cypriot banking system, calming fears of a fresh bout of financial instability in the eurozone.

Investors pushed regional sharemarkets higher on Monday and the euro surged a cent to US130.29¢, buoyed by a radical plan to secure a bailout for Cyprus without imposing losses on people with deposits of less than €100,000. The euro also rose against the Australian dollar, jumping almost a full cent to $1.25.

Hours before a deadline that would have triggered a collapse in the Mediterranean island's financial system, leaders agreed to wind down its second-largest bank and move insured deposits below €100,000 to a "good bank".

In return, the nation will receive an emergency loan of €10 billion from a consortium that includes the International Monetary Fund, the European Union and the European Central Bank.

Under the agreement, Laiki Bank, the nation's second-biggest, will be split into a "good" and "bad" half and gradually wound down. This move will take a hefty toll on bondholders and large deposit holders are tipped to lose €4.2 billion.

Laiki's good half will be merged with the country's biggest lender, Bank of Cyprus. People with uninsured deposits of more than €100,000 in Bank of Cyprus will also face hefty losses believed to be as high as 40 per cent.

Despite the agreement, the cost to deposit holders is likely to deal another blow to investor confidence in the ailing eurozone.

It comes after shareholders in Spain's Bankia - a key lender in the country's own crisis - were told they would be virtually wiped out under a recapitalisation plan announced on the weekend.

Westpac chief currency strategist Robert Rennie said the decision to impose such big losses on people with uninsured deposits in Cyprus - many of whom are rich Russians - could be a worrying precedent.

"You don't have to be a Russian oligarch to have uninsured deposits in European banks," he said.

But IMF head Christine Lagarde said the deal provided "a comprehensive and credible plan" to deal with Cyprus' challenges.

"We believe the plan provides a durable solution to the underlying problems facing Cyprus and places it on a sustainable path to recovery," Ms Lagarde said.

The forced haircut on uninsured deposit holders is a big blow to major investors in Bank of Cyprus - the bank holds the lion's share of the island's Russian deposits.

Westpac also warned that Russia was "hit hard" by the deal.

"Watch for any retaliation, especially aimed at Germany, which has been blamed by Russia for leading the push to hurt depositors in order to limit the size of the European Stability Mechanism loan."