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BERLIN/ATHENS - Rising expectations that Greece will have to restructure its mountain of debt, possibly as early as the summer, sent the euro and the bonds of weak euro zone members tumbling on Monday in a dramatic escalation of the bloc's debt crisis.
German government sources told Reuters in Berlin that they did not believe Greece, which sealed a 110 billion euro ($157.7 billion) bailout from the EU and IMF last year, would make it through the summer without restructuring.
That development, combined with a new threat to Portugal's pending bailout from the success of an anti-euro party in Finnish elections, hammered market faith in the bloc's ability to avert a new wave of contagion to bigger countries like Spain.
After a brief lull in the crisis at the start of 2011, it has blown up again with full force and some analysts are now openly speculating that Greece and possibly other countries could eventually be forced to exit the bloc.
"You may see some countries deciding to leave the euro because they can't deal with the fiscal straitjacket that it imposes on them," Andrew Lynch, a fund manager at Schroders, told Reuters Insider.
A restructuring of Greek debt would be the first by a west European nation in over half a century and represents a challenge of epic proportions for EU policymakers struggling to reconcile the interests of their citizens with the costly steps needed to preserve the integrity of the 17-nation currency area.
The Greek government, saddled with a debt burden that is expected to swell to 160 percent of gross domestic product by 2013, has denied repeatedly that it plans to restructure and a government spokesman in Athens reiterated that stance on Monday, saying "we fully rule out" such a step.
"It would have catastrophic consequences," Bank of Greece Governor George Provopoulos said.
But government sources in Berlin told Reuters that this now looked unavoidable and suggested Greece should move fast, rather than wait until its funding situation gets critical next year.
"Decisive voices within the federal government expect that Greece will not make it through the summer without a restructuring," a high-ranking German coalition source told Reuters.
The euro, which has remained strong through the latest bout of turbulence, fell to its lowest level against the dollar in 11 days and the cost of insuring Greek debt against default shot higher.
Pressure on other so-called peripheral countries mounted as well, with Spanish 10-year bond yields pushing towards record highs near 5.6 percent and Portuguese yields at a new peak above 9.3 percent.
European officials have been at pains to stress that Spain can avoid the contagion that has forced Greece, Ireland and Portugal to seek rescues. Its much larger economy could strain the bloc's resources to breaking point if it did succumb.
But data on Monday showing an accelerated drop in Spanish housing prices in the first quarter and a treasury bill auction which saw yields spike higher will ring alarm bells across the currency area.
In neighbouring Portugal, representatives of the European Commission, European Central Bank and International Monetary Fund were meeting government officials to set the terms for the bloc's third rescue in a year following multi-billion euro deals for Greece and Ireland.
After an election in Finland, however, that bailout could come under threat.
The anti-euro True Finns party scored big gains in the Sunday vote and vowed immediately to push for changes to a Portuguese rescue that is expected to total 80 billion euros when it is finalised by a mid-May deadline.
It may take weeks to find out whether True Finns will become part of a new government in Helsinki and be able to deliver on that threat.
The party that won the most votes in Finland is pro-European and seems unlikely to compromise its stance even if it does end up in a coalition with True Finns.
But the result underscored the extent of public anger in northern Europe at the seemingly unrelenting series of new aid deals for stricken euro zone countries that mismanaged their economies and finances.
Any delay in approving the bailout deal for Portugal beyond May could leave the country scrambling for new sources of funding. It faces an election on June 5 and has warned it will run out of money around the same time.
"It is extremely difficult for politicians in Europe to ignore the strong signal from Finland," said Steen Jakobsen, chief economist at Saxo Bank.
"Ultimately this could mean a move away from bailouts with no burden sharing by private investors and banks," he added, saying the risks of a Greek restructuring before 2013 had increased sharply.
Greece's debt load of 325 billion euros is nearly double the level most economists see as sustainable and far bigger than that of Argentina when it defaulted in late 2001.
In order to return the country to a sustainable path, most economists agree that it needs to wipe away roughly half the value of its outstanding debt, hitting private creditors with significant "haircuts" on their holdings.
But EU leaders have promised not to make private debt holders pay before 2013.
Doing so in the near-term, when the bloc remains vulnerable, could set off a contagion tsunami that engulfs Greek, German and French banks, raises pressure on Portugal and Ireland to restructure, and infects bigger euro zone members like Spain.
ECB Executive Board member Lorenzo Bini-Smaghi has likened the potential impact to the Lehman Brothers bankruptcy in 2008.
Winning creditor agreement for a milder form of restructuring, like a voluntary extension of debt maturities, will be difficult.
And even if it is achieved, it is unlikely to make enough of a dent in Greece's debt burden to ensure sustainability over the longer-term. Markets may view the "restructuring lite" option as merely the first step in a two-stage restructuring, with the real pain yet to come.