* Germany's ZEW outlines insolvency scheme for states
* Proposal may revive divisive debate
* Plan gives three years to reform or face consequences
By John O'Donnell
FRANKFURT, June 26 A leading German economic institute has proposed a model that would allow struggling euro zone states to restructure their debts, resurrecting a sensitive debate that has split opinion in the single currency area.
Discussion on how to deal with highly indebted European countries such as twice-bailed-out Greece has died down as the euro zone's debt crisis has eased and the cost of borrowing for countries in the bloc has fallen, for many to record lows.
On Thursday ZEW, a body that publishes a closely watched bellwether of business confidence in Europe's biggest economy, took advantage of that calm to float an idea too sensitive to face at the height of the crisis.
"We must get to the situation where the restructuring of state bonds doesn't result in disaster," Clemens Fuest, head of the Centre for European Economic Research (ZEW), told journalists in Frankfurt.
"We need a credible insolvency process."
The idea is highly charged because many experts believe that a default by countries in the 18-strong club using the euro damages the single currency. Investors hope the group will stick together to support each other through hard times. Establishing a system to allow countries go bust would dash any such hopes.
Although Fuest said the plan should only be introduced in the distant future, say 2025, the idea could yet gather momentum and shape the response if a country such as Greece or Portugal ran into trouble in the mean time.
Under the scheme, a struggling country would apply for assistance from the euro zone's rescue fund, the European Stability Mechanism (ESM).
The ESM would then give the country a three-year deadline to put its finances in order.
If that failed, the ESM would begin negotiations with owners of the country's bonds, imposing losses and cutting this debt pile to as little as 60 percent of the state's economic output.
It is unclear whether Fuest will win support for his idea in Berlin.
Although Germany played a central role in shaping a similar European framework for banks that envisages deeper losses for their bondholders from 2016, broaching the subject of state bankruptcy would antagonise weaker euro countries.
Fuest conceded that while the so-called viable insolvency procedure for sovereigns would be practical for smaller countries, it would prove difficult to use for big states such as Italy. (Editing by Andrew Heavens)