Greece's big debt denial

(FORTUNE) -- Will Greece be able to dig out of its debt crisis? Not even the oracle of Delphi knows for sure.

From recent headlines, the ancient muse would have reason to feel optimistic: Greece's first ventures back into financial markets since May were successful, calming market jitters. With two short-term bond sales over a span of a week, the debt-rattled government managed to raise $4.53 billion. And it could have sold more -- both auctions were oversubscribed.

After a closer look, however, the oracle's conclusions would be uneasy. The auctions came with a price: yields over 4% indicating markets were still concerned with the possibility of a future default. Greek bonds carry junk ratings, and the cost of insuring them against a default is still high. CMA DataVision, a London-based firm that tracks credit-default swap prices, recently gave Greece a 54% chance of going belly up.

But mention a default, or even a debt restructuring, to Greek government officials, and they'll hear none of it. Their response: We're doing just fine, the three-year austerity plan is working, and a restructuring is not in the cards in any shape or form.

"There's even no discussion about it," says a source inside the finance ministry. "Restructuring is not an option for us." Period. Full stop.

Of course, Greek officials were adamant when the debt crisis first broke out that an IMF bailout wasn't likely either. We now know that logic was wishful thinking at best. Believe what you will, but the debt-saddled country may have no other choice down the road but to restructure.

"Even if Greece does everything by the rules, the odds that Greece's adjustments could work without restructuring are slim," says University of Maryland economist Carmen Reinhart. "They're never zero but pretty slim. Every time you try to diet, it's ugly, and it doesn't get prettier. You know it's what you need to do, but it doesn't make it palatable."

Ultimately it all depends on how you define the term "restructure." A haircut -- where the value of Greek bonds gets trimmed outright -- is not an attractive option politically or for investors. But in a way, markets have already picked up the scissors by factoring in the possibility of an eventual default into lower bond prices. Even the guidelines for the stress tests on European bank debt holdings, to be released Friday, reportedly advised banks to assume a 17% loss on the Greek bonds in their portfolios.

A voluntary debt swap, on the other hand, may be easier to swallow and may help avert a sloppy Argentina-like default, as many economists including Nouriel Roubini have pointed out. Writes Roubini: "An orderly restructuring is unavoidable, desirable and viable in ways that benefit both the sovereign debtor and its creditors."

The terms of such a swap are that the bond value stays the same, the coupon is discounted, and the maturity date postponed, which allows creditors who voluntarily agree to the terms to be paid off in full -- albeit at a later date -- and gives debtors much-needed breathing space. Roubini points out that history shows 90% of creditors in this situation accept the deal.

Indeed, this is already happening quietly. Last month, the Greek Ministry of Finance and the Ministry of Health & Social Welfare announced that the hospital system's three-year old outstanding debts will be settled with zero coupon bonds, amounting to a 19% loss on initial investments.

Greece's austerity program seems to be on track, as the IMF's most recent report puts it, making talk of even a debt swap -- much less a haircut -- seem like fear-mongering. And the "troika" -- as the IMF, the European Central Bank and the European Commission are called in Greece -- is pleased with the results. And it should be: Last week Athens reported the nation's budget deficit fell 46% in the first half of the year, which was more than expected.

But challenges remain, as the IMF report concluded -- and that possibly explains why the government dropped plans to sell 12-month bills. Inflation at 5% is higher than expected, and unemployment, close to 12%, is rising. Meanwhile the economy is slowing down, and the flow of credit to businesses and households is frozen. Even some global retail chains, like German discount supermarket leader Aldi, have decided to pull out of the Greek market altogether. What's more, the government is having trouble raising revenues -- in the first six months of 2010, cash inflows rose just over 7%. The target was 13.7%. With the slowdown, building up cash coffers via taxes is only going to get harder.

Even with the financial support of the IMF and the EU, and even if the prescribed austerity program proceeds without bumps, Greece will have to keep borrowing more, probably at a high cost, just to service its debt obligation. Economists expect Greece's debt to rise as much as 150% of output by 2013. One can't help but wonder if the ensuing pain is worth the cost, especially since Greece might still not be able to sustain its debt. Argentina eventually defaulted because it determined that restructuring costs were too painful.

But in the long run, it may be better for Greece to deal with some short-term pain. "No amount of additional flour will make the bread rise if there is no yeast," writes the chairman of London-based Intelligence Capital, Avinash Persaud. The missing ingredient, he argues, is a debt swap that could cut Greece's interest bill in half.

For Greeks, however, a restructuring of any kind is an anathema. "We do not need it," argues Greek economist Yannis Stournaras. "It would open up a Pandora's box, if it happens."

He may have a point. But given the confusion over what a restructuring might entail, not even the oracle of Delphi would be able to divine correctly which way the default winds would blow the contents of that box, if it opened at all.