'Devastating' Impact
“Restructuring is not a solution, it's a horror story,” ECB council member Christian Noyer said on May 24. His Spanish colleague Jose Manuel Gonzalez-Paramo said last month such a move would “very probably” have systemic consequences “quite likely more devastating than” the collapse of Lehman Brothers Holdings Inc. in September 2008.

While restructuring is “one option” to reduce the country's debt load, “it is better to keep up pressure on Greece” to implement reforms, Dutch Finance Minister Jan Kees de Jager told Germany's Financial Times Deutschland. Greece may need more time to meet its targets, German Finance Minister Wolfgang Schaeuble said in an interview with the Handelsblatt newspaper published today.

Nouriel Roubini, the economist who predicted the global financial crisis, said in Bucharest today that ECB council members' remarks on the impact of a Greek default were “utter nonsense” and could “trigger a bank run in Greece.”

Greek Deficit
The ECB is for now sticking to its line that tougher austerity programs are the only way out of a quagmire that will see the country's debt jump to almost 158 percent of gross domestic product this year. Greece's budget shortfall may average 9.5 percent of GDP this year, the European Commission says. That's the second-largest gap after Ireland.

The Greek government this week endorsed an accelerated asset-sale plan and a package of budget cuts in an effort to meet requirements for a fifth tranche under its bailout agreements with the European Union, the Washington-based International Monetary Fund and the ECB.

Without it, Prime Minister George Papandreou's government would be forced into a restructuring. Credit-default swaps on Greece fell 29 basis points today to 1,388 basis points, according to CMA. That's down from a record 1,473 basis points on May 24.

ECB Rules
The ECB may still find room for maneuver as the Greek bond- market sell-off intensifies on concern that tougher austerity measures won't be enough to ward off a default.

The Frankfurt-based central bank's own rules say that “a suspension, limitation or exclusion of counterparties may be warranted in some of the cases which fall within the notion of the 'default' of a counterparty.”

One option for the ECB may be to embrace a so-called Vienna Initiative proposal floated by Economic and Monetary Affairs Commissioner Olli Rehn, which aims to persuade creditors to buy new bonds from the Greek government when existing ones mature. Just under half of the ECB's 23-member Governing Council is currently in favor of the idea, according to a person familiar with the matter, who declined to be identified because the discussions are private.

“Given all the options on the table, this is probably the one that the ECB could live with,” Citigroup's Michels said.

The Vienna Initiative was a key plank in the IMF-sponsored rescues of Hungary, Romania, Latvia and Serbia in 2009. Under the plan, banks including UniCredit SpA, Raiffeisen Bank International AG, and Societe Generale SA, then the biggest lenders in eastern Europe, publicly pledged to keep their units in those countries afloat by rolling over funding and providing fresh capital if needed.

'Genuinely Voluntary'
The risk for the ECB is that such a proposal would fail to garner enough support to prevent ratings companies classifying the move as a default.

It would have to be “genuinely voluntary,” said Alastair Wilson, chief credit officer for Europe at Moody's Investors Service. “If we concluded that there was an element of compulsion, we would very likely class this as a default.”

That would render Greek bonds ineligible as collateral in ECB refinancing operations, according to council members such as France's Noyer, Germany's Jens Weidmann and Juergen Stark of the Executive Board. Banks have been reliant on the ECB for funding after being shut off financial markets.

'Complete Havoc'
The threat of that happening may force the ECB into a compromise, say Deutsche Bank economists Gilles Moec and Mark Wall. In May 2010, the ECB suspended its minimum credit-rating threshold for Greece, just four months after President Jean- Claude Trichet said that he wouldn't change central bank rules for just one member state.

“There is probably a limit to the ECB's mantra on 'no restructuring,'” they said in a note on May 20. Otherwise it “would have to bear the responsibility of the subsequent crisis for the Greek banking sector. Would the ECB take the responsibility to 'make things even worse'? We seriously doubt it.”

Nor would the damage be restricted to Greek banks. Citigroup estimates that about a third of the county's debt, or 109 billion euros, is held by so-called foreign non-banks including mutual, pension or sovereign-wealth funds as well as insurers. Greek financial institutions own about 29 percent.

The ECB and the 17 national central banks have about 130 billion euros of risk from Greek debt, Andrew Bosomworth, a fund manager at Pacific Investment Management Co., told reporters in Paris yesterday. Germany, France and other euro nations may need to recapitalize their central banks in the case of a default, which might be “inevitable,” he said.

“If you write those down by half, you wipe out the entire capital stock of the Greek banking system,” said Klaus Baader, an economist at Societe Generale in London. “Complete havoc would be wreaked with the ECB's ability to conduct monetary policy.”

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