Analysis - Euro's fate is Merkel's dilemma

Germany's Chancellor Angela Merkel addresses a news conference at the end of an European Union leaders summit in Brussels June 24, 2011.

BRUSSELS (Reuters) - On a rainy Friday night in Berlin, sometime in the next 18 months, Angela Merkel receives a telephone call from the president of the European Central Bank.

Let us imagine the scenario. Any resemblance with reality, as they say in the movies, is purely coincidental.

Greece has once again fallen behind on its deficit reduction targets because of its inability to collect taxes. Privatisation plans are behind schedule and investors are shunning the asset sales because of labour unrest and political instability.

A second EU/IMF bailout cobbled together in September 2011 and forced through reluctant parliaments is falling apart.

The International Monetary Fund's board is no longer willing to release more aid for Athens, which will run out of cash within days, causing the euro zone's first sovereign default.

"Madame Chancellor, it's not looking good. There was a run on a Greek bank today with savers queuing to withdraw their euros," ECB President Mario Draghi tells Merkel. "There is carnage on the financial markets. It's hitting the bond spreads of Spain, Italy, Belgium, even France.

"We have been pumping liquidity into the Greek banking system but we cannot go on. If there is no European decision by Monday, Greece will default next week. And if Greece goes, it will hit banks across Europe, spread panic in the stock and bond markets and drag down other stressed euro zone sovereigns."

Further calls follow from IMF Managing Director Christine Lagarde and European Commission President Jose Manuel Barroso, confirming that Greece has reached the end of the road and saying European leaders must decide within 48 hours how to protect the euro from the consequences of a Greek default.

"Since last year we have declared we would do everything it takes to preserve the euro. Well, now's the time," Barroso says, suggesting that EU leaders hold an emergency summit on Sunday.

No one is recommending a third bailout for Athens after the first two failed to put the country's public finances back on a sustainable path. All now recognise that Greece is insolvent.

Around midnight, U.S. President Barack Obama calls Merkel.

"The fate of the global economy hinges on what you in Europe do this weekend. If you take bold action to resolve the crisis, America will support you, Madame Chancellor," he says.

GRIM OPTIONS

The options facing Merkel are all grim.

How will she explain to voters in parliament next week that perhaps half of the 35 billion euros (31 billion pounds) she pledged in bailout loans to Greece will be lost, not to mention the extra money needed to recapitalise German banks exposed to Greek debt?

Just imagine Monday's screaming headline in mass-circulation Bild: "Broke Greeks burn our billions."

Will she be blamed for her hesitation early in the crisis, when Greece might have been saved at a much lower cost, and go down in history as the former East German who sank the euro?

How can she reassure Germans, haunted by their 20th century traumas of hyperinflation and a worthless currency, that their money is still safe?

Will she succumb to fierce domestic pressure to force Greece out of the euro area, and at what political and financial cost?

Or is there a way out of the crisis that could strengthen the euro for the future and mitigate the huge losses inevitable in a Greek default?

Finance Minister Wolfgang Schaeuble, the most fervent pro-European in Merkel's cabinet, raises an idea which has been discussed quietly but intensively among an inner core of EU finance officials for months despite public denials.

To limit the market meltdown and restore confidence in the wider euro zone, why not swap Greek government debt at a heavy discount for bonds issued by the euro zone's rescue fund, the European Financial Stability Facility (EFSF)?

These new instruments would be jointly guaranteed by euro zone member states and accepted by the ECB as collateral in its refinancing operations, keeping Greek banks alive.

Greece's debt mountain would be roughly halved to 80 percent of its annual economic output in a restructuring deal with creditors. Banks and insurers would take a steep haircut, as write-downs are called, but would get new bonds underwritten by the EFSF. Most private investors will be well prepared by then.

OUTCRY

There would inevitably be an outcry in Germany. "Eurobonds through the back door," "Merkel accepts transfer union," critics in her centre-right coalition and the media would howl.

Merkel's liberal FDP coalition partners might walk out of government, but they are a dwindling force anyway. Rebels among her Christian Democrats could try to bring her down, but they have no obvious alternative candidate.

She would find support among the opposition Social Democrats and Greens if she chose the route of European bonds.

Based on her government's record during the crisis, there are grounds to believe she might ultimately choose the Eurobond solution "to save the euro" on that fateful weekend.

"(The German government) always signal they'll go national but in the end they go European at the very last second," says Henrik Enderlein, professor of political economy at the Hertie School of Governance in Berlin and at the pro-European end of the German debate.

Merkel vowed not to bail out Greece before doing so. She insisted there would be no general bailout fund, only to accept one. She said the EFSF would be temporary, then allowed a permanent rescue mechanism. She demanded compulsory private sector involvement in future bailouts but settled for a voluntary solution.

Up to now, she has vehemently rejected the idea of jointly issuing common euro zone bonds, but that too could change in extreme circumstances.

"There is no real constraint on Germany as long as there is pro-European leadership," says Enderlein, "They wouldn't call it Eurobonds but EFSF bonds."

(Editing by Toby Chopra)