LONDON The euro zone is inching closer to breaking its long-held taboo against a Greek default, but can still escape financial market mayhem and a body blow to the euro.
It all comes down to whether the default is controlled or chaotic.
Officials have been talking to private bondholders for nearly seven months to get them to share the burden of a second international bailout of Greece with taxpayers, who have so far shouldered all the cost.
But there is still no result, and the threat of a forced default - something that politicians have long been adamant must never happen - drew closer on Monday, when euro zone finance ministers rejected what the banks had billed as their final offer.
Last year, the very prospect filled policymakers with dread but sentiment has changed a little.
Bond markets have thus far exhibited little sense of panic at the slow progress towards a deal, while the European Central Bank wiped out fears over a bank collapse by pumping massive amounts of cash to fund banks into the system in December, an offer it will repeat next month.
The other important shift has come from Paris and Berlin who late last year softened their insistence that private creditors should always take a hit in any future euro zone bailouts. They now say the Greek case is unique and will not be repeated.
Safe-haven German debt futures fell to a one-month low, while Italian bonds - used as a bellwether of sentiment towards the region's lower-rated debt - have rallied, driving yields away from levels deemed unsustainable.
Rating agency Standard & Poor's said on Tuesday it did not see any reason for a "domino effect" in the euro zone, if as expected it downgraded Greece's ratings to "selective default" when it concludes its debt restructuring.
Not all types of default need to upset the market, and some would simply say Greece - which has more than 350 billion euros ($460 billion) in debt, or 162 percent of its Gross Domestic Product - is already in default.
"If you ask me whether (the help of the banks) is already a restructuring, it's hard to argue against it," said one market participant, asking not to be named.
"You had an unwind of several financial institutions in the United States, but only Lehman had a negative impact," this person said, referring to the collapse of the U.S. bank in 2008, now seen as the nadir of the credit crisis.
Time is fast running out for Greece, which cannot repay a 14.5 billion euro bond falling due on March 20 without its second bailout. A deal with bondholders needs to come well before that, because the paperwork alone takes weeks.
BENIGN IS PLAUSIBLE
The scenario to be avoided is having no plan in place at all by that time, which would lead to a "hard default" that could see Greece expelled from the euro zone and set a dangerous precedent for other weak euro zone countries.
"The fallout of this is too horrible to contemplate. It would set a precedent that the authorities would struggle to contain," said David Lloyd, head of institutional portfolio management at M&G Investments.
Letting Greece go would show politicians were no longer in control of the single currency, and financial markets would immediately start betting against other weak euro zone members such as Portugal and the far bigger Italy which, if it succumbed, would threaten the currency bloc's very existence.
But other, more likely, default scenarios are more benign even if they are not entirely voluntary.
"A more plausible scenario is a messy default but with Greece remaining in the euro zone. And more plausible still is a deal enabling Greece to refinance," said Lloyd.
A pay-out of credit default swaps (CDS) - instruments to insure against governments not paying back their debts - is another bone of contention for politicians, who have long been keen not to trigger these instruments.
Lehman Brothers triggered widespread market panic on fears that up to $400 billion in CDS would be payable when it collapsed in 2008. But the amounts actually paid out were relatively small, and would be smaller still for Greece.
The maximum that could change hands from a Greek default is $3.34 billion, according to the Depository Trust & Clearing Corporation, a clearing and settlement company.
It is becoming ever more likely that Athens will force at least some creditors into the bond swap deal that it is negotiating with banks, by writing provisions known as collective action clauses (CACs) into contracts.
These would force the conditions of the bond swap on all other creditors, regardless of whether they sign up for the deal or not. Using such clauses to squeeze out bondholders would almost certainly trigger CDS pay-outs.
DICTATE, NOT NEGOTIATE
A third option - far better than a chaotic default but more coercive than a "voluntary" deal - would be a take-it-or-leave-it offer from the troika of international lenders advising Greece in its discussions with the banks.
The mood in Brussels is now leaning more towards such a deal that would dictate the terms on the private creditors rather than negotiate them, two euro zone sources said. But the latter was still the preferred option, they added.
"We are still in Plan A mode," one of the euro zone sources said, requesting anonymity.
Banks agreed in October to cut their Greek debt holdings by 100 billion euros, or a 50 percent loss on the face value of the bonds. The actual accounting losses are around 70 percent -- though most banks have sharply reduced their exposure.
Fears that a euro zone bank could collapse have receded in the past few weeks because of the ECB's long-term liquidity tenders last year, making it less likely that a default would spark a market rout among bank stocks.
"The ECB has made plenty of money available, and the thought that banks may go under just because there's not cash in the till have now subsided," said one investment banker who advises other banks, speaking on the condition of anonymity.
($1 = 0.7665 euros)
(Reporting by Douwe Miedema. Additional reporting by William James, Sinead Cruise and Jan Strupczewski. Editing by Jeremy Gaunt.)