Europe fears Greece is heading inexorably toward default

The dreaded D-word for those struggling with Europe’s economic crisis is no longer just “debt.”

Try “default.”

European politicians, who denied for months that bankruptcy was an option as Greece struggled to bring down an enormous budget deficit, are now beginning to acknowledge the possibility.

Nervous investors appear to increasingly believe default is just around the corner. They have withdrawn billions of dollars from Europe’s stock markets over the last few weeks. Beyond cold-shouldering Greece, investors are punishing European banks that hold huge piles of government debt and pulling back on lending money to traditionally safe countries such as Italy.

On Monday, fears that Athens is heading inexorably toward default and deepening doubts over whether Europe’s leaders have the political will or skill to keep the debt crisis from spiraling out of control sent the region’s stocks tumbling.

Banks in France and Germany scrambled to assure investors that they could survive their exposure to sovereign debt, but were hammered all the same.

In a separate move, Britain unveiled a radical plan to overhaul its banking system to protect ordinary consumers if the institutions’ riskier activities go disastrously wrong, as they did during the global financial meltdown three years ago.

The sharp sell-off in the markets reflected the growing sense that Greece, with one bailout behind it and another one promised, is nearly out of time. Athens is caught in a dispute over the pace of its spending cuts with the European Union and the International Monetary Fund, which have threatened to withhold the next installment of emergency loans, worth about $11 billion, if it doesn’t speed up its reforms.

Without the cash infusion, Greece will probably go bust by the end of October and the default could trigger a worldwide credit crunch.

The drop in the markets also followed official statements and media reports out of Germany suggesting that Berlin, Europe’s paymaster, was beginning to prepare for a Greek default.

The head of the junior party in Germany’s ruling coalition wrote in an article published Monday that there should “no longer be any taboos” when it comes to solving the debt crisis. A well-managed default should no longer be ruled out, Philipp Roesler of the Free Democrats said in the newspaper Die Welt. Other German officials have raised the prospect of Greece leaving the 17-nation Eurozone.

For months, German Chancellor Angela Merkel has flatly dismissed talk of restructuring Athens’ debt. Her refusal to entertain the idea and the conflicting signals now emerging from her government have heightened unease among investors.

Athens proposed a property-tax hike over the weekend to help slash its massive budget deficit. But skepticism prevails over its ability to follow through.

EU and IMF inspectors are due back in Greece this week, and there are signs that the property-tax proposal will mollify them. But speculation remains rife among investors that even if not imminent, bankruptcy is still inevitable.

“We’re moving closer and closer to the deadline here,” said Julian Callow, chief European economist for Barclays Capital in London. “There’s real concern here that Europe doesn’t have an obvious route map to resolve the situation.”

Worse, the debt crisis has widened to engulf Italy, which suffers from a stagnant economy and a staggering debt load of $2.5 trillion. Borrowing costs have hit painful levels for Rome, which has hastened to come up with an austerity plan to satisfy investors.

Any default by Greece would be completely dwarfed by a similar fate for Italy, whose size would overwhelm attempts by other members of the Eurozone to save it.

After being accused of equivocating over spending cuts, Italian Prime Minister Silvio Berlusconi vowed Monday to shepherd the austerity package through the lower house of Parliament as soon as possible.

Berlusconi, badly weakened by a series of financial and sex scandals, is due in Brussels on Tuesday to assure European officials of his commitment to putting Italy’s budget in order.

Heavy exposure to Italian and Greek public debt made France’s three largest banks the biggest losers in the French stock market Monday, which dropped by 4% overall. The three banks — BNP Paribas, Credit Agricole and Societe Generale — could all suffer a humiliating credit downgrade by ratings agencies this week, which would only aggravate their troubles.

Francois Baroin, France’s minister for the economy, denied that there was any threat to the solvency or liquidity of French banks.

“There’s no urgency for the banks, because those that are actually being massacred on the bourse have all the means to respond to this,” Baroin told reporters.

“Whatever the Greek scenario and whatever provisions have to be made, French banks have the means to deal with it,” said Christian Noyer, the governor of France’s central bank.

Germany’s big banks also led the market plunge in that country Monday. The main German index has lost a third of its value in the last two months.

And in Britain, banks were hit on the London Stock Exchange by the government’s announcement that it would try to implement the most drastic shake-up of the country’s financial system in decades.

Reforms proposed by a blue-ribbon commission advocate separating financial institutions’ retail operations from their wholesale and investment activities. That way, Britain’s finance minister said, ordinary depositors will not be hurt if banks suffer major losses through risky investments like subprime mortgages.

Although some banks are wary of the costs and complications involved, Chancellor of the Exchequer George Osborne said such a change would solve “the British dilemma” — namely, “how Britain can be the home of successful international banks that lend to families and businesses without exposing British taxpayers to the massive costs of those banks failing.”

Under the plan, the banks would have until 2019 to complete the switch.

“This may seem a long time. It is,” said John Vickers, the head of the commission that proposed the reforms. “But short-termism got us into this mess, and we need long-termism to build a more stable system for the future.”

henry.chu@latimes.com

Special correspondent Kim Willsher in Paris contributed to this report.