SCENARIOS-The Greek crisis and the future of the euro zone

PARIS Feb 18 (Reuters) - The Greek debt crisis has hurt confidence in euro zone assets and fuelled speculation about the future of the zone, as it struggles to impose fiscal discipline on member countries with very different economic performances.

Following are five major scenarios for how the crisis may develop over the coming year, with assessments of their probabilities and implications for financial markets:

GREECE RESCUES ITSELF

SCENARIO: By the end of this year it becomes clear that the Greek government, under heavy pressure from the European Union, is having success in cutting its budget deficit from 12.7 percent of gross domestic product last year toward targets of 8.7 percent in 2010 and below 3 percent, the EU ceiling, in 2012. Public debt, estimated this year at 120 percent of GDP, looks set to begin falling back in coming years. [ID:nLDE60D0VN]

Credit rating agencies indicate they may not downgrade Greece further this year, easing concern that Greek debt could become ineligible as collateral in European Central Bank funding operations when the ECB is due to tighten standards at end-year. A virtuous circle develops in which shrinking Greek bond spreads reduce Greece's cost of borrowing, further restoring confidence.

PROBABILITY: This may remain the most likely single outcome. Although a 4 percentage point cut in the budget deficit this year is ambitious, the EU has made clear it may demand further steps to meet that target when it evaluates Greece's progress in mid-March and at intervals later in the year. Greek leaders have repeatedly said they will "do what it takes" to hit the targets.

Domestic Greek politics, and the government's ability to impose austerity, may therefore be the key. Here the signs are moderately encouraging; the government enjoys a large majority in parliament and despite grumbling by the old guard in the ruling socialist party, the position of Prime Minister George Papandreou has not been seriously challenged.

A series of one-day strikes by labour unions appears to be symbolic rather than a concerted attempt to block austerity. This week, farmers ended a 30-day blockade of roads and border crossings without obtaining concessions, and the tax officials' labour union called off a one-day strike, saying it saw nothing to gain from industrial action. Opinion polls show most of Greece's 11 million population back the government as long as austerity is imposed equitably. [ID:nLDE61F20Y]

MARKET IMPLICATIONS: The euro EUR=, which has dropped to eight-month lows against the dollar partly because of the Greek crisis, stabilises; bond spreads of weak states throughout the euro zone shrink as it becomes clear Greece will not trigger a "domino effect" involving Portugal, Spain, Italy and Ireland. Greek and other European bank stocks rebound as the easing of the crisis reduces concern that Greek banks could be cut off from market funding and face runs on their deposits.

Some scepticism would remain, however, about the long-term ability of Greece and other countries in the south of the euro zone to maintain fiscal discipline, given the big gaps in economic performance exposed during the global credit crisis. So long-term investors might continue to attach a small "risk premium" to euro zone assets in coming years. [ID:nLDE61320B]

GREECE MUDDLES ALONG IN "SLOW BURN" CRISIS

SCENARIO: Greece makes limited progress towards this year's deficit target, but to a large degree through one-off revenue measures rather than structural reforms which would ensure further improvement. It remains able to borrow in international debt markets, since markets believe the EU will support it if needed, but the 10-year Greek bond spread GR10YT=RR above German Bunds EU10YT=RR stays high around 300 basis points.

Greek bonds and bank shares remain vulnerable to bursts of speculative selling in response to bad news such as poor economic data or failure to implement specific deficit steps.

PROBABILITY: Significant. Rating agencies have said they are not yet convinced that Greece can find a structural fix to its debt problem. Poorer-than-expected Greek GDP data for the fourth quarter of last year showed its recession was still worsening, casting doubt over government estimates of a return to growth in the second half of 2010; this threatens the government's revenue forecasts, makes austerity harder for the public, and could make debt/GDP targets more difficult to hit. [ID:nLDE61B0ZW]

A slow recovery by the euro zone economy this year could help pull Greece out of recession, but it would also bring closer the ECB's eventual tightening of monetary policy, which might hurt Greece's weak economy disproportionately and make its fund-raising even more expensive. MARKET IMPLICATIONS: Greece would remain a significant negative factor for the euro, as markets worried that rich countries such as Germany and France could ultimately become liable for the debts of Greece and other weak southern states.

Bond spreads for the weak states would stay high, and Greek bank shares would remain at big discounts to normal valuations. Markets would continue to speculate that in coming years, one or more weak states might conceivably have to leave the euro zone, unable to cope with its fiscal discipline and the monetary straightjacket which means they cannot resort to currency devaluations or interest rate cuts to aid their economies.

GREECE HEADS TOWARD DEFAULT

SCENARIO: Greece makes little progress in cutting its budget deficit and loses its ability to raise money in international markets on affordable terms; by the end of this year, some form of default or debt restructuring appears likely. Greece is forced to at least consider an exit from the euro zone, perhaps in the hope of rejoining after a currency devaluation has revived its economy.

PROBABILITY: Very low. Though Greece faces a major refunding hurdle in April and May, when about 20 billion euros of bonds and treasury bills come due, a strong bond auction by Spain this week suggested Greek bonds will find buyers. After April and May, refunding pressure will ease for the rest of the year. At 7.8 years, the maturity profile of Greek debt is the second highest in the euro zone and its rollover needs are low as a ratio of total debt, which are positive factors. [ID:nLDE6191EJ]

Most importantly, the EU is likely to intervene financially if necessary to prevent any Greek default. Although public opinion and many politicians in Germany are against such aid, this could quickly change if there were a serious threat to confidence in the euro zone or its integrity -- monetary union is a tremendous political achievement on which Germany's foreign policy has been based for two decades. Last week, EU leaders delivered a vague but unprecedented pledge to help Greece "if needed". [ID:nLDE61A0W2]

MARKET IMPLICATIONS: The threat of a Greek default would drag the euro down sharply as markets speculated about a domino effect of defaults and departures from the euro zone by other weak states. Bank shares around the region would tumble as investors worried about the possibility of a bank run in Greece, and government bonds in peripheral countries would be dumped. Even safe-haven German Bunds might be sold as long-term money, which has stayed in the euro zone during the Greek crisis, left the zone for safer havens such as the Swiss franc and Asia.