FRANKFURT After initially resisting the idea of any Greek debt restructuring, the European Central Bank is warming to the idea of having private investors share the burden of rescuing Greece, potentially clearing the way for a debt swap.
Although the ECB still opposes a cut in the principal of the debt, which would mean full default, it is now believed to be considering a scenario in which credit rating agencies would declare Greece in limited or "selective" default -- minimizing the impact on financial markets and its own balance sheet.
If the central bank decides to endorse this scenario, it will remove a major obstacle to agreement among international creditors on a second bailout of Greece.
In a letter written on Monday, Germany's Finance Minister Wolfgang Schaeuble proposed to the ECB, the International Monetary Fund and euro zone peers that holders of Greek bonds swap them for longer-dated bonds, giving Athens seven more years to work through its 340 billion euro debt pile.
The ECB has not yet given an explicit, public reply to this proposal. But President Jean-Claude Trichet said on the same day that he would be prepared to accept a scheme in which financial institutions in Europe were asked to maintain their level of outstanding credit to Greece.
"That is something, which is not a default, that the European Central Bank would consider appropriate," he said.
A major problem with a debt swap is the likelihood that credit rating agencies would declare Greece in default. The agencies have said that even if the swap were presented as voluntary, they would probably declare a default since it would involve an element of coercion: investors taking part because they fear the consequences of not participating.
A default could destabilize markets and lead eventually to rating downgrades of other weak euro zone states. ECB officials have repeatedly cited the risk of market turmoil in explaining their opposition to a Greek debt restructuring.
A limited rather than full default, however, could solve this problem by minimizing the time which Greece spent in default status and reassuring markets that Athens did not risk defaulting on all its obligations across the board.
Under this scenario, investors would be asked to swap their old bonds for new ones in near-unison, providing more clarity and certainty for investors, rating agencies and Greece itself than they would obtain if different investors rolled over their debt as different bonds matured over a long period.
At the same time, the European Union and IMF would announce a second bailout of Greece, effectively replacing the 110 billion euro rescue which was launched in May last year. That scheme is failing as Athens misses its fiscal reform targets.
Under this scenario, Standard & Poor's, one of the big three rating agencies, would not declare a full default for Greece but a "selective default."
S&P defines this as a situation in which "the obligor has selectively defaulted on a specific issue or class of obligations but it will continue to meet its payment obligations on other issues or classes of obligations in a timely manner." S&P's peer Fitch Ratings has a similar category, "restricted default."
Rating agencies would then be expected to lift their limited default tags from Greece within a matter of weeks, once they had evaluated the swap and decided that it was fundamentally a voluntary deal.
When Uruguay conducted a debt exchange in 2003, it was downgraded by S&P to selective default but was able to return to international credit markets later that year.
Such a solution for Greece, if the rating agencies cooperated, could circumvent a range of difficulties.
The EU wants to avoid a "credit event" that would trigger payouts of insurance contracts on Greek debt, partly to avoid rewarding speculators against Greece. The guidelines of the International Swaps and Derivatives Association, which determines whether credit events have taken place, say that while changing the terms of existing bonds is a credit event, an exchange of bonds for new ones with new terms is not one.
Also, the ECB, which has bought about 45 billion euros worth of Greek government bonds since last year in an effort to calm the markets, is keen to avoid having to book losses on them, which could eat into its capital and might force it to seek fresh funds from euro zone governments.
A full default by Greece could force such losses on the ECB but a limited, temporary one might avoid this.
The ECB has declared it would have to respond to a Greek debt restructuring by cutting off Greek banks from its funding. In the event of a debt swap, the ECB would probably impose a ban on the use of Greek debt as collateral in its money market operations; this would potentially be disastrous for Greek banks being kept afloat by ECB loans.
However, under this scenario the Greek central bank might provide the country's banks with funds through Emergency Liquidity Assistance, a scheme which the Irish central bank has used to support banks in Ireland, an EU official source said.
Such intervention could tide Greek banks over until Greece was taken off limited default status, allowing the ECB to resume accepting Greek bonds as collateral.
Another problem with a voluntary debt swap is persuading investors to take part in it. EU officials are discussing sweeteners, such as collateral, that might be attached to the new Greek bonds to address this problem.
The ECB could also give investors a big incentive to participate in a swap by removing existing Greek bonds from its list of eligible collateral for use in money operations and replacing them with the new bonds.
"The ECB remains the lynchpin in all of this," said Credit Agricole fixed Income economist Frederik Ducrozet.
If the rating agencies considered this too coercive, however, the ECB might adopt a softer approach by applying smaller discounts to new Greek bonds used as collateral than it does to old bonds.
(Editing by Andrew Torchia)