Europe thinks the unthinkable on Greece

BRUSSELS/LONDON (Reuters) - European officials are working on contingency plans in case Greece bombs out of the euro zone, the EU's trade commissioner said on Friday, as European share prices tumbled and Germany warned of continuing financial turmoil.

German Finance Minister Wolfgang Schaeuble, one of Greece's harsher critics, said market unrest fuelled by the euro zone debt crisis could last another year or two. "Regarding the crisis of confidence in the euro ... in 12 to 24 months we will see a calming of the financial markets," he said.

Germany seemed to be increasing pressure on Athens when Greece's government spokesman said that Chancellor Angela Merkel raised the idea of Greece holding a referendum on its eurozone membership -- something Berlin promptly denied.

European shares hit their lowest level since December, depressed by the prospect of a Greek euro exit spreading a wave of contagion in the currency bloc which could engulf much larger economies such as Spain's.

Policymakers insist they want Greece to remain in the euro zone but European Union trade commissioner Karel De Gucht said the European Commission and the European Central Bank were working on scenarios in case it has to leave.

"A year and a half ago there maybe was a risk of a domino effect," De Gucht told Belgium's Dutch-language newspaper De Standaard.

"But today there are in the European Central Bank, as well as in the Commission, services working on emergency scenarios if Greece shouldn't make it. A Greek exit does not mean the end of the euro, as some claim."

Speculation about such planning has been rife, but de Gucht's comments, which were confirmed by a person close to him, appeared to be the first time an EU official has acknowledged the existence of contingencies being drawn up.

A German finance ministry spokeswoman, asked about plans for a possible Greek exit, said without elaborating: "The German government naturally has the responsibility to its citizens to be prepared for any eventuality."

But the European Commission's top economics official, Olli Rehn, later dismissed De Gucht's comments.

"Karl De Gucht is responsible for trade. I am responsible for financial and economic affairs and relations with the European Central Bank." Rehn said. "We are not working on the scenario of a Greek exit. We are working on the basis of a scenario of Greece staying in."

A spokesman for the Commission, the EU's executive, also wrote on Twitter there was no active planning.

"(The) European Commission denies firmly (that it) is working on an exit scenario for Greece," Oliver Bailly wrote. "(The) Commission wants Greece to remain in the euro area."

Confusion increased when Greek government spokesman Dimitris Tsiodras said that Merkel raised with the Greek president the idea of Greece holding a referendum on its euro zone membership next month, together with national elections.

Tsiodras's statements evoked memories of a bitter row between Athens and the EU last year, when Greece's then Prime Minister George Papandreou proposed a referendum on the country's bailout deal -- an idea the EU vehemently rejected, helping accelerate the downfall of Papandreou's government.

Greek political leaders on Friday angrily rejected a referendum and a German government spokesman denied that Merkel ever proposed it. "This is false and we completely dismiss this," the spokesman told Reuters.

World shares slid and German borrowing costs hit record lows as uncertainty about Greece's future in the euro zone and a deepening Spanish banking crisis bolstered safe-haven assets.

Investors were rattled by a ratings downgrade of 16 Spanish banks by Moody's Investors Service, although the move had been expected.

Sentiment has soured to such an extent that an opinion poll showing Greeks are returning to establishment parties which support the country's bailout had little impact.

If they vote that way in June 17 elections, Greece's place in the euro zone would look more secure and the threat of contagion to countries such as Spain would diminish.

The poll, the first conducted since talks to form a government collapsed and a new election was called, showed the conservative New Democracy party in first place, several points ahead of the radical leftist SYRIZA which has pledged to tear up its 130 billion euro bailout program.

"It's up to Greek politicians to explain the reality to their people and not make false promises," Schaeuble told France's Europe 1 radio. "We want Greece to stay in the euro but meet its commitments and that's a decision that's up to the Greeks."

SPANISH LOSSES

The biggest fear for European leaders is that a Greek meltdown, which would surely follow the stoppage of its bailout funds, triggers a domino effect among the currency bloc's weaker members.

Even aside from the contagion threat, they have huge problems of their own.

Spanish banks' bad loans rose in March to their highest level in 18 years, figures from the Bank of Spain showed on Friday, underscoring the problems facing the government as it attempts to clean up the sector.

The Bank of Spain said bad loans rose to 8.37 percent of the banks' outstanding loans, the highest since August 1994 and up from 8.3 percent in February.

Banks beset by bad property loans which could deteriorate further, along with overspending in indebted regions, are the two biggest risks for Spain's public finances.

Investors believe Spain needs to aggressively address these two issues to avoid a bailout and pushed Spanish borrowing costs to euro-era highs this week.

The fact the euro zone crisis is moving back into an acute phase will place it centre stage at a weekend summit of leaders of the G8 top industrialized nations.

President Barack Obama, the G8 host, has urged European leaders repeatedly to do more to stimulate growth, fearing contagion from the euro crisis that could hurt the U.S. economy and his chances of re-election in November.

New French President Francois Hollande is pressing for measures to boost growth rather than cut debt, Britain's David Cameron has become increasingly vocal in demanding Europe acts more decisively, Canada's Stephen Harper has been a frequent critic, and of the euro zone G8 members, Italian premier Mario Monti was calling for pro-growth policies before Hollande was.

That could leave Germany's Angela Merkel, who insists debt-cutting programs cannot be diluted, cutting a lonely figure.

(Additional reporting by Julien Toyer and Jesus Aguado in Madrid, Harry Papachristou and Peter Graff in Athens and Thomas Krumenacker in Berlin; Writing by Mike Peacock; Writing by Philippa Fletcher, Ruth Pitchford and Giles Elgood)

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