By Noah Barkin

BERLIN (Reuters) - Valentine's Day is supposed to be a celebration of love between partners, but that was in short supply when ministers from Europe's single currency zone met on the fifth floor of the Justus Lipsius building in Brussels on February 14.

After a brief lull in their debt crisis at the start of 2011, tensions in the 17-nation euro area had returned and financial markets were piling new pressure on the bloc's weakest members.

Ten days earlier, German Chancellor Angela Merkel and French President Nicolas Sarkozy had sparked an angry EU backlash by unveiling a plan to impose debt limits and harmonize wage policies across the vast economic area of 330 million people.

Deep divisions over the shape of a new anti-crisis package that European leaders had promised to unveil by late March were opening up.

Also hanging over the meeting was a new fear so troubling the finance ministers had taken special care not to discuss it in public -- the rising risk that Greece would have to restructure its 327 billion euro ($470 billion) debt mountain.

The week before, inspectors from the European Union and International Monetary Fund (IMF) had approved 15 billion euros in aid to Athens, the latest tranche of a 110 billion euro bailout package sealed in May 2010.

But Poul Thomsen, the IMF envoy monitoring Greece's economic progress, had coupled that decision with an unusually stark warning to the government of Prime Minister George Papandreou which instantly rang alarm bells for investors.

Without a "significant, broad-based acceleration of reforms", he said, Greece's rescue program was doomed.

Even with the curtains drawn and their words safely muffled by heavy wood paneling in the large Brussels conference room named after Finland's first permanent EU representative Antti Satuli, the ministers were uneasy.

Jean-Claude Trichet, the grey-haired 68-year old president of the European Central Bank, who had travelled from Frankfurt for the meeting, accused the ministers of "shooting at your feet" for broaching the idea of buying up Greek debt and then retiring it to reduce the country's burden.

In the same building nine months before, Trichet had come under intense pressure to allow the ECB to acquire Greek debt on the open market, later pushing this controversial decision through over the objections of German Bundesbank chief Axel Weber. With his term at the helm of the ECB nearing an end, he was desperate to get tens of billions of euros in toxic Greek paper off his books. But governments were not cooperating.

As the barbs flew, Jean-Claude Juncker of Luxembourg, who was chairing the meeting and sat at the opposite end of the room from Trichet in a black suit and lavender tie, reminded participants that it was important to present a positive, united message on Greece's woes to the public.

Staying positive was not easy. To the left of Trichet, wearing a black dress and white Chanel jacket, Christine Lagarde of France grew impatient. Discussion of a Greek default, the former synchronized swimming champion said, should be avoided at all costs as it could unleash consequences beyond the control of the bloc and its members.

"You can't stroke an elephant just a little bit," Lagarde warned, according to confidential minutes of the meeting seen by Reuters.

Elephant indeed. Despite the best efforts of policy-makers to suppress discussion of Athens' problems, the expectation that Greece will become the first western European country to restructure its debts since post-war Germany in 1948 has taken on a sense of the inevitable in the past two months.

Last week a small group of euro zone finance ministers met in Luxembourg and admitted what had been clear to others for some time -- that last year's bailout of Greece had failed to restore confidence in the country's finances and new steps were urgently needed to alleviate its debt burden.

Sources tell Reuters they are now considering throwing more money at Greece and easing the terms of existing loans, possibly in combination with the "voluntary" involvement of Greece's private creditors.

But this strategy will only delay the real pain until a later date.

Most economists now believe that without an aggressive restructuring which forces private creditors to take losses of 50 percent or more on their Greek holdings, the country will not emerge from its downward spiral.

The only obvious alternative -- keeping Greece on EU life support for many years -- seems a political non-starter given the growing opposition to further aid in northern European countries such as Germany, Finland and the Netherlands.

Greece's debt crisis is the biggest challenge the bloc's policy-makers have faced since the launch of their bold currency experiment 12 years ago. European monetary union was always more about politics than it was economics. That's been part of the problem. Now those two factors -- economics and politics -- are on a collision course that could ultimately fracture the bloc, with Greece and other vulnerable countries like Ireland and Portugal forced to consider exiting the euro zone.

That would be a devastating setback for Europe, whose common currency is the culmination of half a century of closer integration.

"Greece's debt is at levels where it is very rare for a country to make it without a restructuring," Kenneth Rogoff, an economics professor at Harvard University and co-author of "This Time is Different", a best-selling 2009 book on debt crises, told Reuters.

THE BENEFIT OF HINDSIGHT

It wasn't supposed to come to this. Last year, when the EU and IMF teamed up to rescue Greece, they mapped out what they believed was a realistic plan for overhauling its ailing economy through a combination of spending cuts, tax hikes and deep structural reforms.

Coupled with an aggressive drive to root out corruption and tax evasion, this austerity was the shock therapy Greece needed to regain competitiveness, reduce its debt and win over investors again, the argument went.

With the benefit of hindsight, however, the scenario mapped out by Greece's saviors looks wildly optimistic.

Predictably, Athens has struggled to curb rampant tax-dodging and suffered repeated revenue shortfalls as a result.

A return to economic growth next year -- envisaged in last year's rescue package -- now looks doubtful, as do plans for Greece to return to the long-term debt markets in 2012 to fill a 27 billion euro funding gap.

Greece's debt load is set to rise to nearly 160 percent of annual output next year, a level that puts it on a par with Zimbabwe.

Other countries have seen their debt shoot up to similar levels, particularly in times of war, without losing access to the capital markets. Japan's debt-to-GDP ratio, for example, is projected to top 200 percent this year. But unlike Greece, a large portion of Japan's debt is held by domestic savers who are in no rush to jettison their holdings. Japan, like most countries, also benefits from having its own currency and a central bank that can tailor monetary policy to its needs.

Greece, by contrast, cannot unilaterally devalue the euro to boost competitiveness, nor convince the ECB to keep interest rates low when much bigger euro zone economies like Germany are thriving and inflation is on the rise.

Crucially, Greece also suffers from a credibility gap, having defaulted on its debt repeatedly over the course of its turbulent history.

"Greece has spent a supermajority of its time as a modern, independent state in default or rescheduling," said U.S. economist Nouriel Roubini. "Indeed, recorded sovereign defaults begin with city-states in ancient Greece."

The verdict of investors, who have pushed the yields on Greek two-year bonds up to an astounding 26 percent in recent days, is clear: a restructuring of Greek debt is now inevitable.

CAN OF WORMS

To ensure their currency bloc survives intact, European policy-makers must come up with answers soon on how and when that will happen. None of their options are attractive and every one of them carries big risks for the euro zone.

Their first priority is figuring out how to plug a funding gap of approximately 65 billion euros that looms for Greece in 2012 and 2013 if, as expected, it cannot return to the markets.

The bloc's immediate solution appears to be to offer Athens more money and simultaneously loosen the terms of the loans it offered last year, by cutting the interest rate it is charging and extending the period over which Greece must repay them to 10 years or more.

A source in Germany's ruling coalition told Reuters this week that these steps could be accompanied by private sector involvement -- in which banks, for example, agree to extend the maturities on their holdings -- on a voluntary basis.

Recent research from JP Morgan suggests banks holding Greek debt on their banking books -- as opposed to their trading books where assets must be marked-to-market -- might be able to avoid impairment charges under a maturity extension if coupon payments were left unchanged.

Euro zone politicians hope that a "soft restructuring" of this kind, with banks playing their part, might make the idea of giving Athens more aid an easier sell to leery constituents.

The problem is that few experts believe it can work.

"Getting investors to participate on a voluntary basis is a huge can of worms," said Andrew Bosomworth, a senior portfolio manager at PIMCO Europe in Munich.

But Greece desperately needs more time to deliver on its fiscal adjustment plan. Papandreou's government has promised to sell off 50 billion euros in state assets by 2015. If some of that money starts flowing in over the next two years, it could help Greece chip away at its debt pile.

Kicking the can down the road also gives European banks additional time to build up provisions for their Greek sovereign debt holdings, reducing the risk that governments will have to recapitalize them later.

The dilemma for Europe is that even with modest private sector involvement, the plan will not put Greece back on a sustainable debt path nor ease market fears that a sizeable "haircut", in which investors are forced to accept a cut in the value of their bonds, will come in 2013, when policy-makers have said they could consider more radical steps.

Throwing more EU money at Athens will also increase the size of the public sector's exposure to Greek debt.

Once 2013 comes around, the only way to provide sufficient relief may be for European governments to hammer their own taxpayers by accepting big losses on the emergency loans they made to Greece. No sane politician will want to do that.

IN THE SHADOW OF THE GUILLOTINE

Delays in dealing with Greece's debt problem increase the likelihood that European governments will pay a high price down the road.

That is the crucial difference between the euro zone's debt crisis and the one experienced by Latin American countries starting in the early 1980s.

In Latin America, banks were given incentives to maintain their sovereign debt exposure over many years. When the day of reckoning finally came with the arrival of Washington's Brady Plan in 1989, it was the financial institutions that had lent the money in the first place which felt the pain.

In Europe, by contrast, the banks holding Greek debt are gradually being bought out by European governments in what former Argentine central bank governor Mario Biejer has likened to a "giant Ponzi scheme".

"If the sword of a debt restructuring must eventually fall in order to render Greece's debt stock manageable, that sword will fall principally on the neck of the official sector lenders," wrote Lee Buchheit, a lawyer at Cleary Gottlieb Steen & Hamilton in New York who helped negotiate Uruguay's 2003 debt restructuring, in a paper on Greece's options last month.

"The original creditors will have swapped place in the tumbrel with official lenders quite literally in the shadow of the guillotine."

Reuters calculations, based on a conservative estimate that official lenders -- EU governments, the IMF and ECB -- will hold about 160 billion euros in Greek debt two years from now, show that even eviscerating the entire value of the debt held by private creditors in 2013 would be insufficient to push Greece's debt-to-GDP ratio down to the EU's formal ceiling of 60 percent.

Even if one assumes the EU and ECB are treated the same as private creditors, the overall haircut would still have to be a whopping 68 percent to return the Greek debt ratio to that level.

Would Europe accept such losses?

Doing so would amount to political suicide for many of the bloc's leaders. For the ECB the blow to its reputation, and future role as lender of last resort would be at least as traumatic.

The central bank bought an estimated 40-50 billion euros in Greek debt at the height of the crisis, but those bonds were bought at a discount and a haircut on them would be manageable.

The real risk to the ECB is via the Greek debt -- both government and government-guaranteed -- that it has accepted as collateral in its lending to Greek and other banks.

When these exposures are combined, they amount to 194 billion euros, analysts at JP Morgan have estimated -- roughly equivalent to the annual economic output of the Czech Republic.

Add in the euro zone's exposure to countries like Ireland and Portugal, which could come under pressure to restructure as well if Greece went down this road, and the risks multiply further.

Fears about its own balance sheet go a long way to explaining the dire warnings from ECB officials that a Greek debt restructuring would unleash chaos similar to that seen after the 2008 collapse of U.S. investment bank Lehman Brothers.

"If the bank exposure was impaired this could be very serious for the ECB," a chief economist at a major European bank said, requesting anonymity because of the sensitivity of the issue.

BANKS EXPOSED

What about the banks themselves?

The hit to the Greek banking system, which holds close to 50 billion euros in Greek sovereign bonds, would be the hardest.

JP Morgan estimates that a haircut of 50 percent on Greek debt now could reduce equity in the Greek banking system to just 4 billion euros, or 1 percent of assets -- a powerful hit that would require recapitalization stretching the country's 10 billion euro Financial Stability Fund (FSF).

However, those losses would be much smaller if a restructuring took place in mid-2013, according to the bank's analysts, as the average maturity on the bonds they hold is five years and roughly 10 billion euros matures each year.

For leaders in Berlin and Paris, giving these banks a few more years to build up provisions and allow some of their Greek debt to mature would seem to make a lot of sense.

HOW DOES IT END?

But what happens once 2013 rolls around?

It seems clear that private holders of Greek debt will be forced to take major losses. What is less obvious is whether that will be enough to deliver Greece the relief it needs and pave the way for its return to the markets.

Until that happens, more European money will need to go to Athens. How long can that go on without sparking a political backlash in Berlin, Helsinki and other European capitals?

German Chancellor Angela Merkel faces an election in September 2013, just as the Greek debt crisis could be coming to its ominous climax. Two years from now, will she be able to sell the idea of keeping Greece on life support to German lawmakers and citizens who are already balking at it?

Rogoff at Harvard University believes the euro zone can emerge stronger from the crisis, but says some form of breakup may be unavoidable.

"I would recommend that Greece take a sabbatical from the euro zone, do a massive currency devaluation and then re-enter at a later date, although I realize there is a very strong political commitment not to let that happen," Rogoff said.

He is not alone. A growing number of economists and bankers who have looked at the Greek debt issue closely are coming to the view that the clash between economic and political forces within the euro zone may lead it to splinter, even if the costs -- to both Greece and other members -- would be huge.

If Greece were to leave the bloc it would have to hive off its bank deposits from the rest of the euro zone banking system as it introduced a new currency, risking a run on its banks and huge disruption for its companies.

Banks across Europe would face losses on their Greek debt, trade flows would be disrupted and social unrest could result.

"Two years ago I would have said it was impossible in theory and practice," a European banker, who requested anonymity, told Reuters.

"Today it at least seems theoretically possible. When I visit Berlin I hear people thinking aloud either about exclusion or about a voluntary exit," he said. "But it would be the worst scenario possible for all concerned. It's a lose-lose-lose proposition."

(Writing by Noah Barkin; Editing by Simon Robinson and Sara Ledwith)

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