* ECB squeeze on funding means banks could run dry
* IOU payments could be needed but hard to unwind
* Temporary ‘exit’ from euro likely to stick
By John O’Donnell and Alastair Macdonald
FRANKFURT/ BRUSSELS, July 7 (Reuters) - The thinning oxygen supply to Greek banks could leave Athens with little choice but to introduce a form of second currency, European officials believe, a temporary means of freezing its membership of the bloc but one that risks its ultimate exit.
The idea of putting Greece’s euro membership on hold - a temporary ‘Grexit’ - was recently raised by Germany’s finance minister Wolfgang Schaeuble.
Greeks say they have no intention of leaving the currency zone, temporarily or otherwise. But a suggestion by Yannis Varoufakis, who quit on Monday as Greece’s finance minister, that Athens might issue IOUs like the state of California did during a budget impasse in 2009, could amount to the same thing.
Facing a massive budget shortfall, California’s then governor Arnold Schwarzenegger issued more than 300,000 IOUs, known as warrants, with a value of almost $2 billion, to pay taxpayer refunds and others due money from the state.
After a few months, the state struck a new budget deal and started to redeem the notes. But unlike California, Greece cannot fix its financial problems simply by passing a new budget; if it issues IOUs, it could probably redeem them only if it receives a future international bailout. Otherwise, the warrants could turn into a permanent parallel currency.
“There was never any possibility that California would leave the dollar. It was more a way to replace bonds and financing on the market than to replace a currency,” said Gregory Claeys of Brussels’ Bruegel think-tank.
“In Greece, it’s a different issue. Once they produced these IOUs there would be no turning back. It would de facto end up in Grexit.”
Although the Greek government appears not to have planned for a parallel currency, officials both in Brussels, home to the European Union’s executive, and Frankfurt, headquarters of the European Central Bank, believe that it could happen.
ECB officials who studied the prospect of IOUs earlier this year concluded that up to 30 percent of Greeks would end up receiving them, rather than payment in euros, people familiar with the matter had said. They might be used to pay pensions and public sector wages, and accepted to pay taxes.
However, the danger that this could lead to Greece’s departure from the euro bloc was already recognised then, and since then the mood has only darkened, making it harder to see how any issuance of IOUs could be temporary.
Some of the euro zone finance ministers gathering on Tuesday in Brussels spoke openly about the risk of ‘Grexit’. They expect to hear new Greek proposals for rescue that will then be discussed by government leaders at a summit later in the day.
Greece’s immediate weak point is its banks, which depend on euros from the ECB to stay afloat. If talks about a bailout programme stumble on without agreement, the ECB will have little choice but to keep a tight strangle-hold on Greek bank funding.
Without support from Frankfurt and if cash runs out, Greece would have to issue some other form of payment to keep its economy alive, said Francesco Papadia, a former top ECB official.
“It would begin with IOUs, electronic transfers. But then it could become a fully fledged currency.”
Quite how, legally, Greece could leave the euro is unclear. The only treaty provision is one allowing states to leave the EU as a whole. There is no law defining expulsion. External debts would still be denominated in euros and importers would need a way to get hard currency.
“Internally, you would have IOUs,” said one euro zone official. “But you cannot trade that outside of Greece. How long will you be able to continue like this? My hope is that they wake up.”
For now, the subject remains a taboo, at least in public, for the leftist government of Prime Minister Alexis Tsipras.
Asked on Sunday, whether Greece was set to introduce its own national currency, deputy Finance Minister Nadia Valavani, retorted: “Get serious.”
But officials in Brussels say the leaders will have to discuss it.
“Discussing Grexit is more likely than discussing a new (lending) programme,” said one European official ahead of the summit.
“Greeks cannot be expelled from the euro zone but they are likely to be put (under) conditions that they will ask to quit,” the official said, speculating that even the 60 euros per day that Greeks are now permitted to withdraw from their bank accounts would have to be reduced.
Hung Tran, Executive Managing Director of the Institute of International Finance, who negotiated an earlier restructuring of Greek debt, said the time to grasp the nettle may have come.
“If they cannot settle their differences, the euro zone leaders should agree on Greece to exit the euro in a planned manner,” he said. “This would be preferable to an uncontrolled accident.” (Additional reporting by George Georgiopoulos in Athens, Francesco Guarascio in Brussels and Andreas Rinke in Berlin; Writing by John O’Donnell; Editing by Peter Graff)