LONDON Speculation is growing in markets that Greece will be unable to avoid a full-blown default, despite two international bailouts and pledges of support from the euro zone's biggest economies.
French President Nicolas Sarkozy and German Chancellor Angela Merkel urged Greek leaders on Wednesday to implement the terms of a bailout plan and said they were determined to keep Greece in the euro zone.
European leaders are adamant Greece will not default but many analysts see it as inevitable and say the process could be messy.
Greek credit default swaps price in a more than 90 percent chance of default based on a 38 percent recovery rate, up from around 70 percent in late May, Reuters calculations based on Markit data show.
Many analysts deem Greece already to be undergoing a so-called "selective default" after EU leaders agreed in July on a second bailout for the country which foresees private investors sharing part of the rescue cost through a debt swap.
Greece has said it only has money until October after its lenders threatened to withhold further funds due to fiscal slippage. Breaking that deadlock is only seen as postponing the problem to December when another fiscal review is due.
Below are some possible consequences for financial markets:
A Greek default would raise pressure on Portugal and Ireland, also in bailout programs, with investors fearing a precedent had been set.
Yields on peripheral euro zone debt would surge, making funding costs increasingly unsustainable for some, with Italian and Spanish yields, for example, rising back toward 7 percent.
This week, fears of a Greek default helped take 10-year benchmark Italian yields close to 6 percent even after a month of regular bond buying by the European Central Bank aimed at keeping yields at affordable levels for the sovereign.
A Greek default that drove peripheral yields higher could push the ECB into even more aggressive intervention, with negative consequences for its balance sheet.
"Spanish and Italian spreads would come under additional pressure, which pushes us closer toward that self-fulfilling prophecy where spreads reach levels which are clearly unsustainable in terms of debt-servicing costs, which leads to concerns over the sustainability of countries' fiscal positions," Rabobank strategist Richard McGuire said.
A Greek default could pose a problem for euro zone banks, with French lenders seen among the most exposed.
Shares in French banks have sold off sharply in recent weeks, partly due to their perceived vulnerability to any deterioration in the euro zone crisis.
French banks are the most heavily exposed to Greek debt, holding $56.9 billion in their portfolio, more than double German banks' holdings at $23.8 billion, according to the latest data available from the Bank for International Settlements.
Moody's on Wednesday cut the credit ratings of two French banks, citing their exposure to the Greek economy.
French banks are also the biggest holders of Italian debt, with a $410.2 billion exposure, followed by Germany with $164.9 billion.
European banks have already written down a minimum of 21 percent of their Greek bonds maturing by 2020 and some have gone even further. RBS took a 50 percent haircut on its Greek bonds.
But in the case of a full-scale default the write-downs could be even more significant, analysts said.
Fears of more write-downs could make banks even more reluctant to lend to each other.
The three-month spread between euro Libor and overnight index swap rates -- a key measure of financial stress stands near its highest in over two years.
"You would get the loss on the Greek debt of course but I think much more important is the funding situation. Who is going to be lending the banks money if you have got euro zone sovereigns defaulting and you are unsure about what is going to happen next?," said Gary Jenkins, head of fixed income research at Evolution Securities.
Banking sector problems would hurt equity markets at large: stock valuations would fall significantly, raising concerns over the ability of corporations to raise capital. This would hurt business and consumer sentiment and further diminish likelihood of a meaningful global recovery, said Rabobank's McGuire.
European stock markets saw their biggest monthly fall since the mid-2009 in August, and have shed nearly 6 percent this month as fears of a Greek default escalated.
"History teaches us stocks can get cheaper, but confidence will be blown so much in the process it will take years to recover," said Louise Cooper, markets analyst at BGC Partners.
An unmanaged Greek default would also cause a sharp fall in the euro versus the dollar from current levels around $1.38, currency strategists said. They said it could drop to around $1.20 or below. The euro lost around 6 percent against the dollar in the first two weeks of September.
(Additional Reporting Jessica Mortimer and Joanne Frearson, graphic by Scott Barber, editing by Nigel Stephenson)