European Central Bank officials may have more scope to cope witha Greek restructuring than they are letting on even as policymakers warn that such a move could trigger the beginning of a“horror story.”

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While German and French officials say the ECB would no longeraccept Greek debt as collateral in its money-market operationsshould the country be forced to default, the ECB's rules are lessclear and only say that such a step “may be warranted” if officialsdeem it necessary. The ECB's rhetoric may be as much about forcingGreece to step up budget cuts as it is about drawing a line in thesand, say Citigroup Inc. and Deutsche Bank AG economists.

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“Without these ECB warnings, the Greeks wouldn't have come upwith the announcement of additional measures,” said JuergenMichels, chief euro-area economist at Citigroup in London. “The ECBshowed early with the eligibility requirements on collateral rulesthat they can stretch the whole thing pretty far.”

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European policy makers are seeking ways to restore investorconfidence on increasing concern that Greece won't be able to repayits debts after last year's 110 billion euro ($155 billion)bailout. While finance ministers are mulling options such asextending maturities, ECB policy makers have argued that such stepscould destroy Greece's banking system and destabilize other nationsin the 17-member euro region.

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'Devastating' Impact
“Restructuring isnot a solution, it's a horror story,” ECB council member ChristianNoyer said on May 24. His Spanish colleague Jose ManuelGonzalez-Paramo said last month such a move would “very probably”have systemic consequences “quite likely more devastating than” thecollapse of Lehman Brothers Holdings Inc. in September 2008.

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While restructuring is “one option” to reduce the country's debtload, “it is better to keep up pressure on Greece” to implementreforms, Dutch Finance Minister Jan Kees de Jager told Germany'sFinancial Times Deutschland. Greece may need more time to meet itstargets, German Finance Minister Wolfgang Schaeuble said in aninterview with the Handelsblatt newspaper published today.

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Nouriel Roubini, the economist who predicted the globalfinancial crisis, said in Bucharest today that ECB council members'remarks on the impact of a Greek default were “utter nonsense” andcould “trigger a bank run in Greece.”

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Greek Deficit
The ECB is for now stickingto its line that tougher austerity programs are the only way out ofa quagmire that will see the country's debt jump to almost 158percent of gross domestic product this year. Greece's budgetshortfall may average 9.5 percent of GDP this year, the EuropeanCommission says. That's the second-largest gap after Ireland.

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The Greek government this week endorsed an acceleratedasset-sale plan and a package of budget cuts in an effort to meetrequirements for a fifth tranche under its bailout agreements withthe European Union, the Washington-based International MonetaryFund and the ECB.

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Without it, Prime Minister George Papandreou's government wouldbe forced into a restructuring. Credit-default swaps on Greece fell29 basis points today to 1,388 basis points, according to CMA.That's down from a record 1,473 basis points on May 24.

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ECB Rules
The ECB maystill find room for maneuver as the Greek bond- market sell-offintensifies on concern that tougher austerity measures won't beenough to ward off a default.

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The Frankfurt-based central bank's own rules say that “asuspension, limitation or exclusion of counterparties may bewarranted in some of the cases which fall within the notion of the'default' of a counterparty.”

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One option for the ECB may be to embrace a so-called ViennaInitiative proposal floated by Economic and Monetary AffairsCommissioner Olli Rehn, which aims to persuade creditors to buy newbonds from the Greek government when existing ones mature. Justunder half of the ECB's 23-member Governing Council is currently infavor of the idea, according to a person familiar with the matter,who declined to be identified because the discussions areprivate.

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“Given all the options on the table, this is probably the onethat the ECB could live with,” Citigroup's Michels said.

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The Vienna Initiative was a key plank in the IMF-sponsoredrescues of Hungary, Romania, Latvia and Serbia in 2009. Under theplan, banks including UniCredit SpA, Raiffeisen Bank InternationalAG, and Societe Generale SA, then the biggest lenders in easternEurope, publicly pledged to keep their units in those countriesafloat by rolling over funding and providing fresh capital ifneeded.

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'Genuinely Voluntary'
The risk for theECB is that such a proposal would fail to garner enough support toprevent ratings companies classifying the move as a default.

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It would have to be “genuinely voluntary,” said Alastair Wilson,chief credit officer for Europe at Moody's Investors Service. “Ifwe concluded that there was an element of compulsion, we would verylikely class this as a default.”

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That would render Greek bonds ineligible as collateral in ECBrefinancing operations, according to council members such asFrance's Noyer, Germany's Jens Weidmann and Juergen Stark of theExecutive Board. Banks have been reliant on the ECB for fundingafter being shut off financial markets.

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'Complete Havoc'
The threat of thathappening may force the ECB into a compromise, say Deutsche Bankeconomists Gilles Moec and Mark Wall. In May 2010, the ECBsuspended its minimum credit-rating threshold for Greece, just fourmonths after President Jean- Claude Trichet said that he wouldn'tchange central bank rules for just one member state.

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“There is probably a limit to the ECB's mantra on 'norestructuring,'” they said in a note on May 20. Otherwise it “wouldhave to bear the responsibility of the subsequent crisis for theGreek banking sector. Would the ECB take the responsibility to'make things even worse'? We seriously doubt it.”

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Nor would the damage be restricted to Greek banks. Citigroupestimates that about a third of the county's debt, or 109 billioneuros, is held by so-called foreign non-banks including mutual,pension or sovereign-wealth funds as well as insurers. Greekfinancial institutions own about 29 percent.

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The ECB and the 17 national central banks have about 130 billioneuros of risk from Greek debt, Andrew Bosomworth, a fund manager atPacific Investment Management Co., told reporters in Parisyesterday. Germany, France and other euro nations may need torecapitalize their central banks in the case of a default, whichmight be “inevitable,” he said.

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“If you write those down by half, you wipe out the entirecapital stock of the Greek banking system,” said Klaus Baader, aneconomist at Societe Generale in London. “Complete havoc would bewreaked with the ECB's ability to conduct monetary policy.”

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BloombergNews

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