17/05/2012 18:32 BST | Updated 17/07/2012 06:12 BST

Signs of Softening on Greece, But Too Little Too Late

Following the failure on 15 May of the Greek president's last-ditch attempt to put together a parliamentary majority willing to back a government of unity, Greece is heading for another general election, probably on 17 June, the outcome of which is unlikely to reassure financial markets. Having finished second in the 6 May election, the leftist Syriza, which is opposed to the terms of Greece's second, €174bn, bailout agreed with the EU/IMF in March, looks set to emerge as the largest party, according to opinion polls. Although unlikely to obtain enough votes to win a majority in parliament by itself, the party would be well placed to lead the next government. This would make reaching an agreement with Greece's international creditors extremely difficult, raising the risk of a Greek exit from the euro and sovereign debt default.

The consequences of this would be dire for Greece and probably the rest of the euro area, as illustrated by the increased pressure on Italian and Spanish government debt and a sharp fall in European bank shares. On May 16th ten-year Spanish bond yields spiked to 6.5%, Italian bonds to 6.15%, levels not seen since late last year.

An awareness of the considerable risks of contagion to large peripheral euro area countries such as Spain and Italy and the threats that this would pose for the euro explains why there has been a slight shift in tone from some EU politicians and officials led by Luxembourg prime minister and chairman of the Euro Group, Jean-Claude Juncker, who are now suggesting that the terms of the Greek bail-out could be softened with deficit reduction targets extended. Previously, the position within the EU was that Greece would not receive any more financial support if it did not honour the terms of the agreement. That would make a debt default inevitable.

But too many concessions from Greece's international creditors on the bail-out targets could cause all sorts of other problems, including a weakening of the credibility of the euro area's commitment to fiscal discipline. As a result, any concessions are likely to be limited and reluctant, which means that the possibility of a Greek exit from the euro and the risks to the euro area that would come with it will remain a major source of uncertainty and instability.

Moreover, even after restructuring part of its public debt in March 2012 Greece's public debt burden still looks unsustainable given the country's dismal economic growth prospects. The Economist Intelligence Unit expects Greece's debt to still be around 160% of GDP at end-2012. We expect Greece to have to undergo a second debt restructuring in medium term, this time involving debt held by its international creditors.