By Swaha Pattanaik
LONDON, Jan 29 (Reuters) - Any EU rescue of Greece would ease financial market pressure on highly-indebted euro zone countries in the short term but undermine one of the fundamental tenets that shape how investors view euro-denominated assets.
Problems which originated in Greece after it sharply revised up its budget deficit have had a wider fallout, prompting speculation that European Union help will be needed to stop a rot that is spreading to Portugal, Spain, Ireland, and others.
These countries' cost of borrowing has risen, investors are demanding hefty premiums to hold the debt of any euro zone country other than Germany, and the cost of insuring such debt against default has leapt.
Traders and funds have caught the whiff of a crisis which they have the power to exacerbate, and are reported to be doing just that, notably by borrowing money to place bets that the price of Greek and many other euro zone bonds will fall.
This has sparked a flurry media reports that the EU may be inclined to find a way around laws which underpin the euro and say that bailing out a euro zone country is not a possibility.
The problem is, any such rescue might ease pressure within the euro zone but would spark a reassessment of how the euro and the euro zone's benchmark government bonds, German Bunds, should be priced relative to U.S. and Japanese counterparts.
"If there is any bailout for Greece then there might be a short-term rally but the market will then -- not unreasonably -- assume there will be rescue packages for others if needed," said Simon Derrick at Bank of New York Mellon.
"That will insidiously undermine the market perception that the euro zone and the European Central Bank is driven by German orthodoxy in terms of monetary and fiscal policy, an assumption that has underpinned the euro over the past decade. This would be a significant negative for euro-denominated assets."
Derrick's analysis of the $22.3 trillion in assets which the bank has under custody or administration already shows sharp outflows from the euro zone, similar in scale to outflows seen in the late summer of 2008 as the financial crisis was erupting.
BAILING OUT ON "NO BAILOUT"?
The EU's so-called "no bailout" clause on which Germany insisted before signing up to the euro was designed to take account of the fact that fiscal policy remained in the hands of national governments after economic and monetary union (EMU)
Its aim was to ensure individual members did not expect other members of the euro zone to help out if they ran up huge budget deficits -- and to ensure financial markets knew that.
Any sign that the European Union is inclined to turn a blind eye to this rule would mark a fundamental shift that would have market repercussions.
"A bailout would be negative because they really shouldn't have any such thing -- EMU is based on a couple of tenets and that was one of the most significant ones," said Steve Barrow, head of G10 strategy at Standard Bank in London.
It might be possible for the EU to find a way a way around this problem that doesn't violate the letter of the law, not least because the political will that led to the creation of the euro is still intact.
For example, European Monetary Affairs Commissioner Joaquin Almunia said on March 3, 2009, that the euro zone had a way of bailing out its members if they faced a crisis but declined to give any details of the solution. [ID:nL3900798]
Possible scenarios of how this could work have since surfaced [ID:nLDE60R2G5], but at the end of the day, the market implications would be clear.
"Even under a "soft" bailout, what you would do is stretch the credit quality of solid issuers in favour of weaker issuers" in the euro zone, said David Schnautz, interest rate strategist at Commerzbank in Frankfurt.
"No matter what kind of vehicle is used, this would affect the price of protecting against default, spreads, and outright yields would rise" for all euro zone issuers. (Reporting by Swaha Pattanaik; Editing by Toby Chopra)