LISBON For euro zone policymakers, the question of how and when to restructure Greece's mountain of debt is a conundrum wrapped in an enigma. There are no easy answers and every option poses big risks for the currency bloc.
A year after Greece secured a 110 billion euro ($159 billion) bailout from its European partners and the International Monetary Fund, a loose consensus is emerging that some form of restructuring is inevitable.
Its economy mired in recession, Greece is struggling to meet the fiscal targets set out for it in exchange for the rescue, and market confidence in its finances is deteriorating daily.
Barring a dramatic turn of events, it seems unlikely Athens will be able to return to the capital markets next year to raise the 25 billion euros it needs to service its debt.
The German finance ministry have now come around to the view that a restructuring is unavoidable, even if the Greek government, European Central Bank, European Commission and IMF continue to rule it out in their public statements.
What does seem clear is that European governments and institutions will face a stark choice over the coming year -- either they provide Greece with additional money in the hope market sentiment turns positive at a later date, or they bite the bullet and agree, together with Athens, to pursue western Europe's first debt restructuring in six decades.
The first option looks like a political no-go, given growing opposition among voters to further bailouts in northern Europe.
The second option raises the unsavory prospect of European countries accepting losses on the loans they have already provided to Greece and throws up the biggest question of all -- how to restructure the debt so as to avoid a new wave of contagion that could crush the euro zone and spread elsewhere.
Increasingly, it appears that the answer to this question may be incompatible with what should be Europe's central goal in this exercise, namely putting Greece on a sustainable debt path.
"The Greek government has no interest in caving in to a restructuring today. Their approach is to wait in the hope that things get better," said Daniel Gros, director of the Center for European Policy Studies in Brussels. "The problem is that every day the choice gets a little more uncomfortable."
POLICY DIVISIONS, PUBLIC BACKLASH
Complicating the decision-making process are the myriad actors involved in this Greek tragedy -- from Prime Minister George Papandreou in Athens to Chancellor Angela Merkel in Berlin, their counterparts in other capitals, the European Central Bank in Frankfurt and European Commission in Brussels.
Each of these players has different interests and priorities, both political and financial.
Merkel and Papandreou face elections in late 2013 and will be reluctant to make unpopular choices close to that date. Jean-Claude Trichet's term as ECB president ends in half a year and he will be loath to pursue a radical new course before then.
All of this raises the risk of delays and a messy public debate over the appropriate course of action for Greece, with potentially damaging consequences for public sentiment.
Already in traditionally pro-European countries like Finland, anti-euro feelings are on the rise and threatening the EU's efforts to shore up its weakest members.
The longer the bloc's debt crisis drags on and Greece's debt woes are left to fester, the higher the risk that leaders find their room for maneuver on policy limited by angry citizens.
"Most intelligent people know there has to be a significant restructuring to ease the burden on Greece, and we're not talking about a painless extension of maturities, but wiping away a large portion of the debt," said Charles Grant, director of the Center for European Reform in London.
"My worry is that the longer they leave it, the stronger the euroscepticism becomes. When they finally do decide to restructure the debt it will be too late."
Greece has roughly 325 billion euros ($469.8 billion) in debt. By 2013, its burden is expected to approach 160 percent of gross domestic product (GDP) -- nearly double the level most economists see as sustainable and far bigger than that of Argentina when it defaulted in 2001.
The strongest arguments against a restructuring have come from the ECB, which holds an estimated 40-50 billion euros of Greek sovereign debt itself.
THE LEHMAN SPECTRE
Lorenzo Bini Smaghi, a member of the ECB's Executive Board, warned last week that a restructuring in which private creditors were forced to take "haircuts," or losses, on their Greek debt holdings would be akin to the 2008 decision to let U.S. investment bank Lehman Brothers go bankrupt.
It would crush Greek banks, which hold roughly a third of the country's sovereign debt, and have "devastating effects" on social cohesion and democracy in the country, he predicted. The risks to banks outside of Greece cannot be ignored either.
The latest figures from the Bank for International Settlements show German banks had $26.3 billion worth of exposure to Greek sovereign debt and French banks $19.8 billion as of September 2010, relatively small sums when compared to total banking assets in Europe's two largest economies.
But when you add in their exposure to Greek banks and non-bank private entities -- groups that could be hammered by sovereign debt writedowns -- the figures show German and French banks are owed a much larger $103.3 billion.
Broaden that out to include Ireland and Portugal, two euro zone countries which could also face pressure to restructure if Greece goes down this path, and the contagion risks are clear. The exposure of German and French banks hits $379.8 billion.
"Contagion is clearly a very serious issue. No one in their right mind would advocate doing a restructuring if it can be avoided," said Andre Sapir, a senior fellow at the Bruegel economic policy think tank in Brussels.
But despite these risks, Sapir believes a restructuring of Greek debt should be done in the next one to two years.
A major argument in favor of quick action is that by 2013, more than half of Greece's outstanding debt will be held by the EU and IMF. At that point, even the radical step of writing off the total value of Greek debt held by the private sector may not be enough to put the country on a sustainable debt course.
"Whatever restructuring has to be done, it should occur before 2013. Otherwise it will be that much more painful," Sapir said. "At some stage you have to take your losses."
The problem with moving quickly is that European governments have pledged not to force any "haircuts" on private lenders before 2013, when the EU's new rescue mechanism is in place.
As a result, German officials are reportedly exploring milder options, including swapping Greek debt at market prices for paper guaranteed by the euro zone, similar to the "Brady Bonds" of the late 1980s, or buying up bonds and then retiring the debt or extending maturities.
But convincing debt holders to go along with these schemes voluntarily will be difficult. They may also not make enough of a dent in Greece's debt load to restore investor confidence. Markets may view them as the first steps in a two-stage restructuring, with the real pain yet to come.
Despite its flaws, this "restructuring lite" path may be the only one that is politically acceptable for now.
The alternative is keeping Greece on EU life support for years or moving ahead in the next year or so to eviscerate the value of privately-held Greek paper, with all the contagion risks and reputational damage to the euro zone that implies.
Lee Buchheit, a lawyer at Cleary Gottlieb Steen & Hamilton in New York who advised Uruguay on its 2003 restructuring, says regardless of what the EU decides, one message is clear from the 50-odd sovereign restructurings of the modern era:
"A sovereign debt crisis can be a painful experience for both the debtor and creditors; a mismanaged sovereign debt crisis can be a catastrophically painful experience."
(Editing by Mark Heinrich)