Greek Debt Deadlock Spreads Fears

The Wall Street Journal

By CHARLES FORELLE

BRUSSELS—Top euro-zone politicians, engaged for months in a string of meetings that have failed to bring agreement on how to provide more aid to Greece, are trying furiously to stamp out the flames of contagion licking at Italy and Spain.

Fears have also ricocheted elsewhere: Ireland's prime minister said Wednesday in his parliament that it was time for European Union leaders to "grasp the nettle" of the debt crisis, adding that Moody's Investor Service's move late Tuesday downgrading Ireland's debt to junk status was caused by the bloc's failure to respond adequately.

European leaders are planning an emergency summit in coming days on Greece's intractable debt problem, according to people familiar with the matter. The country's soaring debt pile shows no signs of shrinking, and the euro zone's solution so far, which has been to keep lending Greece money that private financial markets won't provide, hasn't changed that.

What EU leaders once ruled out—a default by a euro-zone nation—has firmly entered the sphere of the possible.

Some form of action to cut Greece's debt load by handing losses to its creditors may be the only option left to prevent that debt from spiraling out of control. "We are more and more moving toward a recognition that some form of restructuring is inevitable," says Fabian Zuleeg, chief economist of the European Policy Centre, a Brussels think tank. "The volume of debt is not manageable."

Fitch Ratings Wednesday dropped Greece three notches to triple-C and said default "is a real possibility."

The sharp shift in the discussion has been driven by three major factors. First, after months of relative calm, financial markets suddenly turned sharply negative on Italy last week. With the deadlock on Greece, investors have become worried that the EU won't be able to act coherently to stave off a crisis in the euro zone's third-largest economy and its second-biggest debtor. That has increased pressure to break the deadlock.

Second, Greece appears close to the limit of how much pain it will endure to close its budget gap. Last month, the government of Prime Minister George Papandreou nearly collapsed over the EU's insistence on €28 billion ($39 billion) in fresh budget cuts as the price for disbursing a piece of the already-agreed bailout pool. Mr. Papandreou suppressed an internal party revolt, but he remains weak.

Demand for sharper cuts could well trigger more political instability. But Greece may need them, if it is to stay on the fiscal path outlined by its rescuers. Fresh budget data released Monday showed that Greece's government in the first half of 2011 took in less revenue than projected and spent more. Its central-government deficit is 28% higher than where it stood after the first half of last year.

Third, a middle road appears to have been swept away. As recently as late June, European finance ministers insisted they'd find a way to share some of the burden of a new aid package with Greece's private-sector creditors without triggering a debt default. But the major ratings companies have made it clear there is likely no such avenue: A plan that harms private creditors almost certainly implies default.

In a report released Wednesday, the International Monetary Fund said it "may not be possible" to avoid a temporary form of default if policy makers proceed with plans to restructure Greece's debt in even a modest fashion.

The closing-off of that road has, paradoxically, opened other avenues. If there is going to be a default, says Sony Kapoor, managing director of Re-Define, an economic think tank, European policy makers "thought that they might as well get something worthwhile from it."

Tuesday, at a meeting with his euro-zone counterparts, Dutch Finance Minister Jan Kees de Jager set the tone by declaring that an orderly default is "not excluded anymore." What will be included is yet to be determined—not least because the European Central Bank remains staunchly opposed to any form of default.

If that opposition is overcome, several options could ease Greece's debt burden by transferring either losses or risk onto private-sector creditors.

One is a "maturity extension," under which bondholders who are supposed to be paid in the coming months and years are given new bonds of the same face value that come due later. That wouldn't reduce Greece's aggregate debt, but it would relieve some of the pressure on euro-zone countries to come up with funding.

A more extreme option would be to give bondholders new debt with a face value that's a fraction of what they currently hold. That would quickly slash the debt burden, but it would just as quickly force European banks and other creditors to bear losses.

Another option under consideration is lending Greece money to buy back its own debt on secondary markets at a discount. But, for this plan to work, creditors would have to be willing to sell at a loss. At the same time, the very fact that Greece would be a heavy buyer could drive up prices and reduce the possible discount.

—Eamon Quinn in Dublin and Stephen Fidler in Brussels contributed to this article.

Write to Charles Forelle at charles.forelle@wsj.com