Greece's plight is yardstick for the troubled eurozone

Europe's currency union faces its stiffest credibility test in eight years of existence over whether Greece, a chronic spendthrift, should be punished or bailed out.

The problems of one sovereign nation have become a problem for the 15 other countries that share the European Union's single currency.

They fear the profligacy of one member could unleash a domino effect, savaging the credibility of the euro as a strong currency underpinned by fiscal discipline.

"Economic policies are not just a matter of national concern but European concern," European Commission chief Jose Manuel Barroso said last week, as the EU executive drafted recommendations for getting Greece back into shape.

The truth about Greece's sick economy only emerged last October, when newly elected Socialist Prime Minister George Papandreou announced his conservative predecessors had misreported official figures.

The public deficit for 2009, he disclosed, was around 12.5 per cent of gross domestic product (GDP), instead of the 3.7 per cent Greece had previously predicted.

Under the eurozone's rules, a country is supposed to keep its deficit to within 3 per cent of output.

Already struggling with a debt of more than €294 billion ($580 billion) - equivalent to 113 per cent of GDP - the Government has to borrow €54 billion this year to keep afloat.

The scandal over the dodgy data prompted credit rating agencies to downgrade Greece's sovereign debt rating, adding to the burden.

Greece last week had to pledge interest rates of 6.1 per cent - around twice that paid by Germany, deemed the safest borrower in the eurozone - to investors willing to buy €8 billion in bonds.

Papandreou now has to race to assure the markets he is serious about a belt-tightening scheme for bringing the country back to the EU's 3 per cent limit by 2012.

Greece must return to the market in April and May, when €20 billion of debt mature, and analysts say it cannot afford to refinance such a sum with interest rates so high.

So far, the official line is to deny any need of a bailout. Behind the scenes, though, financial officials around the eurozone are working frantically to at least plan for a rescue operation.

One reason is prestige. If Greece turns for help from the International Monetary Fund (IMF) or cash-rich China, it would be an astonishing humiliation for the institutions that run the euro, which last year jousted with the dollar as the world's prime currency.

Another concern, though, is practicality. If Greece goes bust, speculators would turn to the next in line of the euro's transgressor nations, says Geoffrey Yu, a currency strategist in London at UBS AG.

Ireland, Spain and Portugal have large public deficits, of 11.7, 10 and 8.3 per cent expected in 2010, respectively, as well as high levels of indebtedness. Italy, too, is also weak on both counts.

These imbalances, coupled with high unemployment and recession, have been a trigger for currency traders to offload the euro, which last week traded at under US$1.40 ($2), compared with a peak of US$1.50 in November.

The deficits "weaken trust in the euro and endanger the cohesion of monetary union," the commission's economic and financial directorate warned in a draft document leaked by German news weekly Der Spiegel.

Some voices are urging a vast bond for Greece to see off the speculative vultures. It would be underwritten by all 16 of the 27 EU states which have the euro.

"Now is the time for us to stand shoulder-to-shoulder with Greece - not to abandon the country to the mercy of world markets," the Socialist leader in the European Parliament, Martin Schulz, declared last month.

But whether this tactic is allowed under the treaty of monetary union is unclear. It also runs into political problems, given the anger at Greece's past falsifications and its easy ride on the euro gravy train.

Too easy a bailout would lift pressure on Greece to fix its problems.

Too harsh a bailout, though, would worsen tensions in a tinder-box country where unions will launch anti-austerity strikes next week. So a tense and complex game is set to unfold in the coming weeks.

It will pitch the central European authority against national sovereignty; the Greek Government against the Greek trade unions; and pro-bailout members of the euro-zone against anti-bailout members.

On Thursday, the commission will unveil an evaluation of the Greeks' economic plans. The package will also be scrutinised at a special EU summit on February 11, followed by finance ministers on February 15-16.

Insiders in Brussels say euro-zone countries are pinning their hopes on calmer markets to enable Greece to see out the crisis by itself.

Ultimately, though, they may have little option but to sign a cheque, if only to protect themselves.

"We are all in the same ship," the Economic Affairs Commissioner, Joaquin Almunia, sighed last week.