IRELAND'S credit rating will be cut to 'junk' and Greece will be classed as being in default if a leaked German plan to hit holders of Greek bonds is put into effect, analysts said last night.
The news follows a leaked letter from the German finance minister Wolfgang Schaeuble to fellow finance ministers.
He said bondholders should take a "substantial role" in the new Greek bailout by waiting an extra seven years for debt to be repaid. A seven-year extension would allow Greece to defer around €30bn per year of debt payments.
The debt would still be due, but the extra time could allow Greece to get its affairs in order before paying off the loans.
Even so, the scheme would be considered a default by ratings agencies, analysts said last night.
This is despite the fact that there is no call to force losses on lenders to Greece.
ING Bank's Padhraic Garvey said any bond exchange that is driven by solvency concerns is classed as a default, which would hit Greece immediately if Schaeuble's plan was adopted.
It's a purely technical form of default, but it would mean a review of the ratings of other at-risk countries.
"The net result, we suspect, is that a rollover could trigger the rating agencies to cut Portugal and Ireland to junk, meaning that prices get smashed, given that real money investors would then dump Irish bonds into a vacuum," Harvinder Sian, a bond strategist at RBS said yesterday.
That would damage Irish hopes of a return to the bond markets over the next year and hurt any effort to wean the banking sector off its dependent on the ECB.
The Schaeuble letter was circulated as details of the new Greek bailout were being worked out.
The bailout is due to be signed off at a meeting of eurozone finance ministers on June 23 and 24 but debate is raging on how to make sure that private sector investors share some of the burden.
Schaeuble's letter sets down a marker for that debate.
The letter calls for a "quantified and substantial contribution" from bondholders before a new bailout can be agreed.
It means a bond due to be repaid next year will be swapped for a new bond that would only be repaid eight years from now. The debt would still be repaid in full.
ING's Garvey said the German plan was workable, even if it triggered a default.
European banks and the ECB hold more than half of all Greek government debt, he said.
Banks could account for the new bonds at full value as assets, even if they plummet in markets. More importantly, banks find it difficult to say no to ministers.
"Banks have been through a difficult period, so it's difficult for them to say no. The relationship between banks and governments is long-term," said Mr Garvey.
The plan sets Germany on a collision course with the ECB, which says default should be avoided because of the potential disruption to markets.
It wants Greek bonds to be replaced with new bonds by the same lenders, on a voluntary basis, as the debt falls due. One of Europe's most influential bankers last night said extending the maturity on Greek debt could work.
The head of the Association of German Banks said it could be "one possible solution" for an aid package, but he wants it to be voluntary.
"Any potential required restructuring of Greece can only take place on a voluntary basis," said Andreas Schmitz.
Germany is ultimately the guarantor of the finances needed to raise rescue loans for Greece, giving it a powerful voice in bailout talks.
The ECB has played a pivotal role in keeping all of the bailout countries and much of the European banking system afloat since the crisis started.
The clash means that there is now no consensus on how to move ahead with the next phase of the Greek bailout.
That as much as anything will weigh on sentiment across markets over the coming weeks.