German Chancellor Angela Merkel has ruled out a “classic haircut” on Europe's loans to Greece, but European law leaves sufficient wiggle room to work out other forms of debt restructuring if the political will is there.
Merkel is trapped between fierce domestic opposition to going soft on Athens, and growing international pressure to grant Greece debt restructuring if it delivers convincing reforms in a deal to keep the country in the eurozone.
The international pressure may be becoming overwhelming, with Germany's closest ally France determined to do all its can to prevent a “Grexit” and the International Monetary Fund (IMF) and United States pressing for debt relief as part of a deal.
“When a government really is determined to have its way, and political correctness is on its side and there is international pressure, they will always bend the rules,” said Gunnar Beck, a specialist on EU law at the SOAS, University of London.
Merkel has said a debt haircut, or writedown, for Greece would be illegal - a position that may raise concerns for advocates of such a move given previous legal challenges in Germany to European Central Bank policy measures.
However, the ECB has won backing from Europe's top court and constitutional experts believe that with Greece a way could be found to execute a debt haircut, or a rescheduling that would amount to the same thing by easing Athens' repayment burden.
The legal restrictions centre around the so-called “no bailout clause” in the Lisbon Treaty, which stipulates: “The Union shall not be liable for or assume the commitments of central governments”.
This makes it illegal for one member country to assume the debts of another.
But Greece owes debts to numerous creditors, with different legal positions. The creditors include the IMF, the ECB and Europe's twin bailout funds - the European Financial Stability Fund (EFSF) and the European Stability Mechanism (ESM).
A haircut, or even a rescheduling, of the roughly 18 billion euros of Greek bonds held by the ECB appears a non-starter, as this would breach a ban on state financing by the central bank.
But legal experts say the ESM, which has so far lent Athens 141.8 billion euros ($156.52 billion), is a separate case.
“There is no legal limit to releasing Greece from part of its debts held by the ESM,” said Kai Schaffelhuber, partner at Allen & Overy law firm in Frankfurt, distinguishing the ESM from the 'Union' mentioned in the Lisbon Treaty.
“(In the case of the ESM) it is not the Union that assumes the debt, but the ESM is a separate international organisation .... different from the Union.”
Europe's legal set-up therefore gives government leaders sufficient space to strike a debt restructuring of some kind for Greece if they want to. The issue is how far they go with any reprofiling as part of a potential deal with Greece.
German Finance Minister Wolfgang Schaeuble said on Thursday the IMF was correct in saying Greece's debt was not sustainable without a haircut, but he added: “I think the leeway we have ... is very low.”
By talking tough, the German government is taking a hard negotiating stance, keenly aware of the domestic opposition in Germany to writing off Greek debts. But it is leaving the door open to negotiations - if not by much.
This means Berlin is reducing the scope for any restructuring deal as any agreement that went too far would leave Merkel and Schaeuble unable to sell it at home, or risk legal challenges.
One key may be to ease the debt burden by “reprofiling” loans, so they are paid off over a longer period, but without reducing the nominal value of what is eventually repaid - the latter would amount to the “classic” haircut Merkel ruled out.
“The legal issue is sufficiently vague that the politicians probably do have scope to come up with a solution involving pretty significant maturity extensions without running a material risk of invalidation by the courts,” said Ian Clark, a partner at White and Case in London who advised on a 2012 restructuring of Greek debt to private investors.
“But the more extreme the solution, the bigger that risk is going to be,” he added.