THESSALONIKI, Greece (Reuters) – Greek Prime Minister George Papandreou said on Saturday he would do whatever it takes to rescue his country from bankruptcy and stay in the euro zone, as doubts in Europe grew over its membership in the bloc.

Sending a message to international lenders increasingly frustrated with delays in reforms and missed fiscal targets, Papandreou said his government was determined to take the difficult decisions and make the sacrifices needed.

“We decided to fight the battle to avoid a disaster for the country and its people and to stay in the euro,” he said in his annual economic speech at a trade fair in the northern city of Thessaloniki. “Any delay and wavering is dangerous for the country.”

Anger at the country’s failure to meet fiscal targets under its EU/IMF bailout has reached boiling point, prompting senior euro zone policymakers to cast doubt on its ability to avoid default or even its membership in the single currency.

The embattled premier, who was heckled by angry labor unions on Friday, said he would redouble efforts to fight endemic tax evasion, a main hurdle in achieving fiscal targets.

His Finance Minister Evangelos Venizelos said earlier Greece may even take additional fiscal measures in 2011 to make up for budget deficit slippage that threatens the disbursement of an 8 billion euro EU/IMF loan tranche.

Venizelos pledged to further cut the civil service payroll, push privatizations and deepen labor market reforms.

Civil servants, who have seen about a fifth of their wages slashed, will suffer more after the government decided to put thousands of them in a so-called “Labor Reserve,” in which they will draw 60 percent of their salary and possibly face dismissal if they find no other public sector job within a year.

But austerity measures are throwing the economy into an ever deeper recession. GDP will shrink by more than 5 percent this year, Venizelos said, topping earlier projections in its third straight year of contraction.

PUBLIC DISCONTENT

More than 20,000 protesters gathered in the northern city to mark Papandreou’s speech. Police fired tear gas at youths smashing shop windows and setting fires on the main shopping streets. Police said 106 people were detained.

Demonstrations were organized by civil servants, students, taxi drivers and even football fans. Some restaurants in the city shut down to protest a VAT hike that took effect earlier this month.

“We are suffering an unprecedented tax raid … we deeply worry about tomorrow,” George Kasimatis, chairman of Greece’s Chamber of Commerce Federation, told Venizelos during the conference.

About 7,000 police were patrolling the city’s streets, cordoning off the fairgrounds. Ministers canceled plans for their usual walkabouts in the city and Papandreou avoided touring the fair in the morning, as prime ministers traditionally do on the event’s first day.

While vowing to keep its side of the bargain, the Greek government sharply criticized its EU partners for delaying ratification of a second, 109-billion-euro bailout for the country, agreed by euro zone leaders on July 21.

“Europe must rise to the challenge and move toward implementing the July 21 decisions, to put an end to the Sisyphean ordeal the Greek people is going through,” said Development Minister Mihalis Chrysohoidis.

“Doing nothing is disastrous for all of us,” he added.

A G7 source said the troika (EU/IMF/ECB), which suspended talks with Athens last week in frustration at Greece’s struggle to stick to its deficit reduction plan, would probably come up with a form of words in its next report to allow the next tranche of bailout funds to be paid.

But the working assumption is that Greece will not avoid default indefinitely.

However, a bond swap plan for private bondholders, which is part of the second bailout plan and is supposed to ease Greece’s debt payments was progressing well, Venizelos said.

“The private sector is responding very well to the PSI (private sector involvement),” he said, without elaborating, one day after an initial deadline for banks to express interest in the scheme expired.

(Additional reporting by George Georgiopoulos and Yannis Behrakis; Writing by Dina Kyriakidou; Editing by Janet Lawrence)

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PARIS (Reuters) – The resignation of the top German official at the European Central Bank could hardly have come at a worse time for euro zone policymakers as they grope for a way out of the deepest crisis in the single currency’s 12-year history.

The ECB is the one institution that has kept the euro zone afloat in the sovereign debt crisis and prevented a bond market meltdown. The European Union has no federal government or common fiscal authority and speaks with many dissonant voices.

Juergen Stark’s departure from the ECB’s Executive Board in despair at the policy of buying government bonds to prevent the crisis spreading comes as policymakers in Berlin and beyond are preparing for the growing possibility of a Greek default.

It seems bound to complicate the next round of crisis management because it has injected the poison of inter-state politics as well as ideological division into the independent central bank.

“It’s the ECB that is holding the show together, so anything that weakens the ECB is bad news,” said an EU official involved in financial crisis management.

Stark’s walkout will further sap the ECB’s credibility with Germany’s conservative financial establishment, which saw the bond-buying as an improper means of financing government debt, and among voters in Europe’s largest economy.

That could make greater fiscal integration in the euro zone politically harder to achieve at a time when Chancellor Angela Merkel is coming to realize that a big leap forward in economic governance is needed to preserve the single currency.

It risks importing a north-south divide, between self-styled virtuous creditor countries and peripheral states seen as profligate and feckless, into the central bank.

At worst, Stark’s departure may constrain the ECB’s ability to act decisively in the coming months when the debt crisis enters an even more dangerous phase.

HAMSTRUNG

“This comes at a very, very bad time and it’s certainly serious,” said Jean Pisani-Ferry, director of the Bruegel economic think-tank in Brussels.

“If the ECB is shackled in its ability to buy Italian and Spanish bonds and at the same time we have to do a real restructuring of Greece’s debts, with a proper haircut, we risk a contagion shock spreading to other countries. If the ECB is hamstrung by a lack of consensus, that is the risk.”

A growing number of policymakers, as well as market economists, are convinced it is only a matter of time before Greece, which keeps falling behind on its fiscal targets, will have to default.

A source at this weekend’s G7 finance chiefs’ meeting in Marseille said the troika of EU, ECB and IMF inspectors, who suspended talks with Athens last week, would probably find a formula in its progress report to allow the next 8 billion euro ($11 million) tranche of bailout funds to be paid in October.

That would keep Greece going for a couple more months until European parliaments approve new powers for the EFSF rescue fund to give preventive credit lines to euro zone member states, buy bonds in the secondary market and lend money to recapitalize banks.

The source said the German Finance Ministry was increasingly convinced that Greece will not be able to avoid default for much longer, so ring-fencing the euro zone’s weakest debtor and limiting contagion will be crucial.

Even when the EFSF has its new powers, it will require the unanimous agreement of the 17 euro zone member states to use them, with the German parliament having just gained a bigger oversight role on those decisions. Political hurdles abound.

Markets may bid up euro zone bond yields again in anticipation of the ECB pulling out of bond-buying and handing over to the inexperienced EFSF, traders say.

The ECB has bought a total of 135 billion euros’ worth of Italian, Spanish, Greece, Irish and Portuguese bonds so far.

The rescue fund may find itself short of firepower in a crisis. It will have about 380 billion euros in uncommitted funds. Italy alone has 1.9 billion euros of outstanding government bonds, of which 45 percent are held by foreigners.

HARDER LINE

The replacement of Stark on the ECB board by the more pragmatic German junior finance minister Joerg Asmussen, the seasoned crisis manager proposed by Berlin on Saturday, may reduce ideological tensions at the central bank.

But it could also force incoming ECB President Mario Draghi, who succeeds Jean-Claude Trichet on November 1, to take a harder line on ending bond purchases and sticking to the bank’s core mandate of fighting inflation.

Draghi has already warned governments, including his native Italy, that continued bond-buying cannot be taken for granted.

“The next step will be increased pressure on the ECB to keep its hands clean. Stark is from the German school that sees this kind of intervention as bad in principle,” said Josef Janning, director of research at the European Policy Center in Brussels.

“His likely successor will be less orthodox and more of a political crisis manager. But Stark may use his new freedom to speak out. That could make things more complicated for Merkel and for Draghi,” the German political scientist said.

Stark’s resignation could also affect international confidence in the ECB and the euro zone at a crucial moment.

“Politics has never been completely absent from the ECB but this has now been reinforced. This awakens the idea that the ECB is still a structure that amalgamates national institutions and views, not primarily individuals belonging to its board,” Pisani-Ferry said.

“You have to think about how this looks from New York. It looks as if these people can’t even sit around the same table and work things out.”

($1 = 0.729 Euros)

(Additional reporting by Annika Breidthardt in Marseille and Luke Baker in Brussels; Editing by Kevin Liffey)

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LONDON (Reuters) – The euro and growth-linked currencies may fall on Monday, hit by a lack of concrete measures from Group of Seven finance chiefs to address either faltering growth, the escalating euro zone debt crisis, or exchange rate volatility.

The dollar, yen and, to a lesser extent, Swiss franc are set to advance with more investors seeking safe-haven currencies on the back of rising financial market stress.

That will raise the risk of more solo intervention from Japanese and Swiss authorities.

The flight to safety should drive core government bonds like German Bunds and British gilts higher, leading to wider spreads over euro zone peripheral debt, while European banking shares may ease on mounting worries about contagion engulfing bigger economies like Italy and Spain.

Finance ministers and central bankers from the Group of Seven industrialized nations pledged to respond in a concerted matter to a global slowdown. However, they offered no specific steps and differed in emphasis on Europe’s debt crisis.

That will likely offer little solace to investors who had expected some sort of coordinated policy response from G7 policymakers at a time when stock markets have been falling and global growth in showing increasing signs of stalling.

“As this falls short of any commitment to undertake co-ordinated action in currency markets, investors are likely to react with disappointment when trading resumes on Monday,” said Mansoor Mohi-uddin, head of foreign exchange strategy at UBS.

He expected Japan to stay on intervention watch.

Japan’s finance minister, Jun Azumi, said he met with little resistance to further intervention at the G7 meeting. Japan last intervened in the currency market on August 4 to topple the yen from a record high against the dollar.

“We expect Japan’s authorities will act again unilaterally if dollar/yen tests its post-war lows of 75.95 yen. As a result we think investors should instead keep favoring the dollar now when they seek safe-haven currencies,” UBS’s Mohi-uddin said.

The dollar index, which measures its performance against a basket of six currencies which includes the euro, yen and sterling, rose to its highest in six months at 77.276 on Friday.

In a bullish signal, it closed above its 55-week moving average at 77.01. Resistance was seen at the base of the weekly Ichimoku cloud around 78.05, while strong resistance was at the 38.2 percent retracement of the index’s fall from a high of 88.71 on June 7, 2010 to a low of 72.696 on May 4, 2011 which comes in at 78.80.

The dollar is set to make strong gains against the euro, which last week fell to its lowest in six months, at around $1.3627. The euro posted its biggest weekly fall since mid-August last year, with many looking for it to test $1.35 in the near term.

EURO ON THE WAY DOWN

The euro also fell sharply against the safe-haven Japanese yen on Friday, dropping to its lowest in nearly a decade. It ended the week at 105.85 yen, and a break below the psychologically key 105.00 level could see it drop toward 100 yen in coming weeks, analysts said.

Howard Wheeldon, a strategist at BCG Capital Partners, said the weekend’s developments provided little confidence to investors in the euro zone, and the coming week will see increased volatility in stock markets.

That could hurt the euro more in coming days.

The euro was sold off last week after European Central Bank President Jean-Claude Trichet shifted the monetary stance from a hawkish bias to a more neutral one.

The shock resignation of ECB board member Juergen Stark, which highlighted sharp divisions within the central bank over purchases of government bonds in the secondary market and concerns that Greece may not secure its latest aid tranche from the IMF/European Union, also added to the euro’s woes.

Investors will also likely be unsettled by a weekend report from Der Speigel magazine that the German finance ministry was looking at scenarios that included Greece abandoning the euro.

Indeed, latest data from the Commodity Futures Trading Commission showed speculators added to their bearish bets against the euro in the week to September 6.

“With $1.40 going last week, I think the euro could fall to $1.35 in the next few days,” said Michael Derks, chief strategist at FXPRO. “The dollar be will the currency that will gain from safe-haven inflows given the risk of intervention in the yen and the line in the sand that has been drawn on the Swiss franc by the Swiss National Bank.”

On the charts, near term support was seen at $1.3426, a low hit on February 14 and from where the euro started its move to a 17-month high at $1.4939 struck on May 4.

(Reporting by Anirban Nag; Editing by Dan Lalor)

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CANBERRA (Reuters) – French Foreign Minister Alain Juppe said on Sunday he believed the Chinese currency was undervalued and would raise the issue when he visits Beijing shortly.

“We believe that the yuan is undervalued at present. We will certainly discuss this with the Chinese,” he told reporters on his last day of a visit to Australia. He IS traveling back to France via China.

(Reporting by Rob Taylor; Editing by Mark Bendeich)

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THESSALONIKI, Greece (Reuters) – Debt-laden Greece’s government vowed on Saturday to stay the course of austerity, sending a message to its increasingly frustrated lenders it will do everything it takes to avoid a bankruptcy that would rock the euro.

Anger at the country’s failure to meet fiscal targets under its EU/IMF bailout has reached boiling point, prompting senior euro zone policymakers to cast doubt on its ability to avoid default or even membership of the single currency.

But Finance Minister Evangelos Venizelos countered the talk, telling its lenders his government remained fully committed to its bailout plan.

“We are absolutely determined, without weighing any political cost, to fully meet our obligations to our institutional partners,” he said in a speech in the northern city of Thessaloniki.

Venizelos pledged to further cut the civil service payroll, push privatizations and deepen labor market reform.

“If these things don’t change, we won’t survive, we won’t get out of the crisis,” he told business people in a conference.

Civil servants, who have already seen about a fifth of their wages slashed, will suffer more after the government decided to put thousands of them in a so-called “Labour Reserve,” in which they will draw 60 percent of their salary and possibly face dismissal if they find no other public sector job within a year.

“We must prove wrong all those who say that Greece is incapable, or unwilling, or a pariah, or doesn’t deserve to be in the euro,” Venizelos said.

But austerity measures are throwing the economy into an ever deeper recession. GDP will shrink by more than 5 percent this year, Venizelos said, topping earlier projections in its third straight year of contraction.

PUBLIC DISCONTENT

Recession is breeding public discontent and thousands of disgruntled civil servants, students, taxi drivers, and even football fans, are expected to march later on Saturday in Thessaloniki.

The protests are scheduled to coincide with a major economic policy speech by Prime Minister George Papandreou at the Thessaloniki Trade Fair, the country’s biggest economic event.

Taxi drivers have called a 24-hour strike. Thessaloniki restaurant owners said they would shut down on Saturday to protest a VAT hike that took effect earlier this month.

“We are suffering an unprecedented tax raid… we deeply worry about tomorrow,” George Kasimatis, Chairman of Greece’s Chamber of Commerce Federation, told Venizelos during the conference.

Police presence is felt throughout the city, with about 6,000 officers patrolling the streets on foot or motorbike. Three people were detained for carrying face masks.

Papandreou, who was heckled by protesting labor unionists in Thessaloniki on Friday, avoided walking through the fairgrounds in the morning, as prime ministers usually do on the event’s first day.

While vowing to keep its side of the bargain, the Greek government sharply criticized its EU partners for delaying ratification of a second, 109-billion-euro bailout for the country, agreed by euro zone leaders on July 21.

“Europe must rise to the challenge and move toward implementing the July 21 decisions, to put an end to the Sissyphean ordeal the Greek people is going through,” said Development Minister Mihalis Chrysohoidis.

“Doing nothing is disastrous for all of us,” he added.

A G7 source said the troika (EU/IMF/ECB), which suspended talks with Athens last week in frustration at Greece’s struggle to stick to its deficit reduction plan, would probably come up with a form of words in its next report to allow the next tranche of bailout funds to be paid.

But the working assumption is now that Greece will not avoid default indefinitely.

However, a bond swap plan for private bondholders, which is part of the second bailout plan and is supposed to ease Greece’s debt payments was progressing well, Venizelos said.

“The private sector is responding very well to the PSI (private sector involvement),” he said without elaborating, one day after an initial deadline for banks to express interest in the scheme expired.

(Additional reporting by Yannis Behrakis; Editing by Toby Chopra)

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MARSEILLE, France (Reuters) – The yen took a back seat at the Group of Seven finance ministers’ meeting, which grappled with Europe’s debt crisis and global economic slowdown, but Japan said it met little resistance to further intervention.

The G7 economic powers gave a muted reaction to Japan’s call to endorse its right to unilateral action against speculators pushing up its currency, but Japanese officials and some analysts said the subdued response suggests the G7 could let Japan intervene in the market again if needed.

“We intervened in August and I told the (G7) that we will continue to watch the situation closely and flexibly, and take decisive steps against speculative moves,” Finance Minister Jun Azumi told a news conference late on Friday after the G7 talks.

“No countries voiced opinions against our explanation. I believe we gained understanding toward our view on currencies.”

A senior finance ministry official said the G7 had not ruled out the chance of solo intervention by Japan.

In the run-up to the meeting, Japanese officials vowed to seek G7 understanding on Tokyo’s intentions to counter yen rises that threaten to derail a recovery from the March earthquake which tipped the world’s No. 3 economy into recession.

“Japan could not ask for more as it just avoided blunt criticism from other countries against its past intervention,” said Masafumi Yamamoto, Japan chief forex strategist at Barclays Capital in Tokyo.

On Saturday, Azumi told reporters that U.S. Treasury Secretary Timothy Geithner had not voiced opposition in an early morning bilateral meeting.

“He was smiling but did not refute. He appears to understand the situation,” Azumi said.

LITTLE CHANCE OF CONCERTED INTERVENTION

Japan has conducted three currency interventions over the past year — one rare co-ordinated action with the G7 shortly after the March 11 disaster and two solo moves.

Yamamoto said further intervention to curb excess volatility

may not meet international opposition as long as it was not done frequently or aimed at guiding currency rates toward specific levels as Switzerland did this week by setting an exchange cap on its soaring currency.

Japan’s economy is now recovering from recession, while Europe and the United States face a slowdown, so Tokyo has been having a hard time convincing its G7 counterparts of the need for intervention.

European Central Bank President Jean-Claude Trichet said early last month that currency interventions “have to be made on the basis of a multilateral consensus,” signaling displeasure at Japan’s solo action on August 4.

In Marseille, Japanese officials including Bank of Japan Governor Masaaki Shirakawa blamed the yen’s rise on global economic woes that have been amplified by Europe’s debt crisis — the central topic of debate at the G7 talks.

“Such an argument may have discouraged Europe from being critical of Japan’s intervention. As a result, Japan may have gained a free hand in intervening in the currency market,” said Takahide Kiuchi, chief economist at Nomura Securities.

Japan faces higher hurdles persuading the G7 of the need for a joint intervention, which is seen as more effective in curbing excess currency moves.

On Friday, the G7 issued a statement that said exchange rates should be determined by markets and pledged: “We will consult closely in regard to actions in exchange markets and would cooperate as appropriate.”

“The G7 is not in a situation where it needs to do something about currencies as it focuses on how to balance public finances while facing slowing economy,” said Barclay’s Yamamoto.

“The foreign exchange market is reflecting debt problems in the West but it is not causing problems. So G7 must be feeling there’s no use dealing with currencies to resolve the market situation.”

(Editing by Catherine Bremer/Mike Peacock)

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TAIPEI (Reuters) – Fitch Ratings warned on Thursday that it might downgrade China’s credit rating within two years as the country’s banks struggle with debt loads following a lending surge to help lift the economy during the 2008 financial crisis.

It also said that Japan, weighed down by a public debt load twice the size of the $5 trillion economy, faced a greater-than-even chance of a downgrade in part due to a political impasse that is stalling plans to clean up its finances.

Asia’s two biggest economies are in the ratings firing line alongside Europe and the United States as they deal with massive debts built up during the global financial crisis.

Andrew Colquhoun, head of Asia-Pacific sovereign ratings at Fitch, told Reuters in an interview that China’s local currency debt rating could be downgraded over the next 12 to 24 months.

“We expect a material deterioration in bank asset quality,” he said. “If the problems in the banking system pan out as we expect or are even worse over the next 12 to 24 months, then that would incline us to take the rating downwards.”

Fitch downgraded the outlook on China’s long-term local currency debt to negative from stable in April because of concerns about the country’s financial stability following a lending surge encouraged by Beijing to help maintain economic growth during the global downturn.

Fitch’s China long-term local currency rating is AA minus, its fourth highest level, on a par with Italy and a notch below Spain, Reuters data shows.

Fitch has sounded the loudest warnings of the three main ratings agencies about the surge in lending in China and is the only one with a negative outlook on the long-term local currency debt rating.

China reported local government debt of 10.7 trillion yuan ($1.67 trillion) as of the end of 2010. More than 347 billion yuan in urban construction investment bonds were issued in the five years to 2010.

Last month, China’s top banking regulator Liu Mingkang said work to clean up local government debt was progressing smoothly, the latest comment from officials to try to reassure skeptical capital markets that risks were manageable.

Colquhoun said non-performing loans at Chinese banks were about 2 percent of the total, but if lending to local government financing vehicles was appropriately classified, the figure would be more like 6-7 percent.

“That by itself is sufficient to exhaust the banks’ internal absorption capacity,” he said. “So any further deterioration in asset quality beyond that… would lead to a requirement for sovereign support, which then affects the sovereign credit profile.”

While in general terms it was known how much stimulus during the financial crisis cost European countries and the U.S., Colquhoun said, because in China it was done through the banking system, “in a nutshell we don’t know how much it cost.”

“We haven’t seen the full cost come through yet.”

FURTHER DETERIORATION?

There was a risk that asset quality could deteriorate further because bank lending was still running at a fast pace, Jonathan Lee, Fitch’s senior director of financial institutions, said at a later media briefing.

Lee said Fitch estimated bank loans would increase this year alone by 18 trillion yuan.

“This is the equivalent to 55 percent of China’s GDP, which is an extremely high number and a potential problem for banks’ asset quality,” he said.

Japan’s credit rating has already been cut this year by Fitch’s rivals, Standard & Poor’s and Moody’s. Like Fitch, they cite the inability if Japan’s leadership to come up with a plan to reduce the debt load over time.

“We think the ratings on current trends are more likely than not to go down,” Colquhoun said. “To shore ratings up at their current level we need to see a credible fiscal consolidation plan.”

The three major agencies rank Japan’s credit ratings at their fourth highest levels. However, both Fitch and S&P have a negative outlook, suggesting further rating downgrades unless Japan is able to come up with a credible plan to sort out the debt.

“Our confidence that we will see it is not high because of the track record of the politics,” Colquhoun said.

Japan’s government spokesman declined to comment.

Hopes now rest on Yoshihiko Noda, appointed last week as Japan’s sixth prime minister in five years, to forge a political consensus in the divided parliament, or Diet. The costs of reconstruction following the March 11 earthquake and tsunami and the recession it triggered is adding to Japan’s debt burden.

“We’ll see if Mr Noda has the formula to break the logjam in the Diet. But if we don’t, then the ratings will be coming down.”

(Additional reporting by Faith Hung in Taipei and Tomasz Janowski in Tokyo; Writing by Neil Fullick, Editing by Dean Yates)

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LONDON (Reuters) – China has no timetable for the full convertibility of its currency though it plans to make the yuan convertible on the capital account eventually, the country’s central bank chief said on Thursday.

“China has published a plan (that includes convertibility for the yuan on the capital account). Up to now, the plan does not define a clear timetable for full convertibility,” People’s Bank of China Governor Zhou Xiaochuan said.

He was commenting on media reports that quoting the president of the European Union Chamber of Commerce in China as saying he had been told by Chinese officials that Beijing would make the yuan fully convertible” by 2015.

Zhou also said China saw no “special urgency” in having the yuan including in the basket used to calculate the value of the International Monetary Fund’s Special Drawing Rights (SDR), though it welcomed discussion of the idea as a way to improve the global currency system.

Asked by reporters how global economic imbalances should be addressed, Zhou said it needed a “concerted effort by all the major economies in the world.”

He said the G20 was a good forum to discuss such coordination.

Finance ministers and central bankers of the Group of Seven (G7) developed nations, which does not include China, are meeting in France this weekend to discuss the global economy. Zhou did not mention the G7 meeting.

Even as they coordinate, “each country should act to sort out their own domestic imbalances,” he said, adding that China was working to boost its domestic demand.

Asked how China would respond to further quantitative easing by the U.S. central bank, Zhou said he understood that the United States needed to secure a recovery of its economy but he added: “There should be coordination and when setting monetary policy, countries should consider the impact on global liquidity.”

China and other emerging economies criticized the last round of U.S. quantitative easing as destabilizing for global markets.

Zhou said China welcomed London’s aspirations to become an offshore trading center for the yuan but said the city appeared to be moving “faster than we expected” and the market would ultimately decide.

Internationalizing is a “long term process” of exploration and experimentation, he said.

He said any move by London to trade the yuan would not affect the status of Hong Kong as an international center because the territory had strong markets and played an important role in China’s development.

(Reporting by Sebastian Tong; Editing by Toby Chopra)

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BERLIN (Reuters) – Anger at Greece’s failure to meet fiscal targets that are a condition for its international bailout is nearing breaking point in Berlin and other European capitals, with senior politicians now talking openly about the possibility of Athens exiting the euro zone.

Horst Seehofer, the head of the Bavarian Christian Social Union (CSU), was the first prominent figure in Germany to suggest publicly that Greece might eventually be forced to leave the 17-nation single currency bloc in an interview in the Bild newspaper on Wednesday.

But he was expressing what many lawmakers and ministers in the German capital have been whispering behind closed doors for weeks, according to well-informed sources.

German Finance Minister Wolfgang Schaeuble has ramped up his rhetoric since “troika” inspectors from the European Union, International Monetary Fund and European Central Bank suspended talks on payment of a new aid tranche to Greece last week due to backsliding on its deficit targets.

And the Dutch prime minister said in a proposal published on Wednesday that fiscal violators who refused to give up sovereignty over their budgets to a new European “discipline” czar should leave the bloc.

“Countries which are not prepared to be placed under administratorship can choose to use the possibility to leave the euro zone,” Mark Rutte said in the proposal which was sent to parliament.

The troika inspectors are due to return to Athens next week, but their abrupt departure has reinforced the feeling in northern Europe that Greece’s government is simply unwilling to take the draconian steps required to meet the conditions of the 110 billion euro bailout they sealed in May 2010.

In July, European leaders were forced to come up with a second package of roughly equal size for Greece because the first one proved too small. But that second package, due to be ratified by national parliaments in the coming months, is now in danger.

“A debate about a second program for Greece is, in view of the difficulties in the current program for Greece — paying out the next tranche – very premature,” Schaeuble told parliament in a speech on Thursday.

Earlier he called the situation “serious” and said it was “up to Greece as to whether it can fulfill the conditions that are necessary for membership in the common currency.”

German Chancellor Angela Merkel rebuffed talk of a Greek exit earlier this week, warning of a dangerous “domino effect” were the bloc’s weakest member to leave.

HOTEL CALIFORNIA

There is no legal framework for a country leaving the currency zone and the costs of an exit could far outweigh the pain of staying in.

“As things stand, secession is highly costly and very difficult, and expulsion is impossible,” UBS economist Stephane Deo wrote in a note this week.

He likened the euro zone to the “Hotel California” in the hit 1977 song by rock band The Eagles, which includes the line: “You can check out any time you like, but you can never leave.”

UBS said the consequences of a weak country exiting would include sovereign default, corporate default, the collapse of the banking system and of international trade.

It estimated the costs per person in an exiting country at 9,500 to 11,500 euros in the first year — or 40 to 50 percent of gross domestic product (GDP).

A senior EU official told Reuters that a euro zone exit was inconceivable, because of the turmoil that would ensue.

“No, because if you get 17 minus one, you’ll end up with 17 minus four, five, six or eight,” the official said. “The euro zone is not a cafe where you go in and you go out. The financial and monetary interdependence is so big, so strong.. that the fate of one member creates problems for all of the others.”

He added: “I can assure you that Germany is as convinced as I am that leaving the euro zone is no option at all for anybody.”

But Greece’s failure to meet its targets has raised serious questions about whether weak euro zone countries have sufficient incentive to reform and is an acute, growing source of concern in Berlin.

What incentive does a country like Greece have to meet incredibly tough targets in the face of fierce domestic public anger if it knows that its partners in the euro zone can’t afford to let it collapse financially and allow it to leave?

“If sovereigns in the Euro area believe that they are either too large or too interconnected to be allowed to fail, then there is a significant moral hazard problem,” David Mackie, an economist at J.P. Morgan, wrote in a note on Thursday.

“This has clearly been an issue with the ongoing under performance in Greece, and it became apparent in Italy in August regarding ECB bond purchases. But the music for this dance may be about to stop. The departure of the troika from Athens last week suggests a high level of frustration about what Greece is delivering, and there are now serious doubts about the disbursement of the sixth tranche of the original bailout package.”

(Reporting By Madeline Chambers; Editing by Patrick Graham)

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BRASILIA/SAO PAULO (Reuters) – Among the legions of Brazil-watchers who were caught off guard by last week’s 50 basis point interest rate cut, count President Dilma Rousseff.

“This was a surprise for us, too,” a source close to the president said in describing her reaction. “We thought it would be unchanged, or they (the central bank) would cut by 25. No one expected 50.”

While Brazil’s central bank seems to have surprised virtually everyone by slashing its benchmark Selic rate to 12 percent last Wednesday, officials with knowledge of the decision told Reuters that the move was justified by “ugly” data indicating that the economy will slow more sharply than expected, and could possibly contract, in coming months.

The darker outlook could further roil Brazil’s currency, stock and interest rate futures markets, which have already suffered heavy volatility since the rate cut. Wednesday was a market holiday in Brazil.

Many investors are concerned that the cut was premature or motivated by political pressure. They worry that inflation, already at a six-year peak of 7.2 percent, could stay high.

The bank is due on Thursday to release the minutes of its August 31 meeting, which will provide a more detailed accounting of the rationale behind its first rate cut since 2009.

The officials, who spoke on condition of anonymity to describe the bank’s thinking before the minutes are published, said data shows Brazilian manufacturers and other companies have been hit hard by the global economic crisis that intensified in August. That pessimistic view is supported by recent anecdotal evidence such as Ford (F.N) and Volkswagen’s (VOWG.DE) separate decisions to cut back auto production here.

Brazilian consumers are also feeling the effect of the five interest rate hikes that had occurred this year prior to last week’s cut, the officials said. They said the central bank is now working with a forecast of just 3.5 percent economic growth for this year — less than half last year’s pace, and below most private-sector estimates.

The main IPCA consumer price index could even decline on a monthly basis in coming months, they said.

“Our numbers are really, really ugly,” one official said.

The account of Rousseff’s surprise at the cut, which was corroborated by a second official, would seem to dispel concerns that the central bank acted because of political pressure from the president, who has made no secret of her desire for Brazil’s rates to converge over time with those in the developed world. While Brazil’s central bank does not enjoy formal independence, Rousseff and previous presidents have in practice given it autonomy to make rate-setting decisions.

Yet Rousseff’s reaction raises other, perhaps equally worrying questions: If the decision surprised even her — a trained economist who meets regularly with central bank chief Alexandre Tombini — then was the rate cut clearly premature?

Also: Why didn’t the bank communicate its intentions better to markets and officials beforehand? And what are the risks if the economic forecasts prove wrong — and Brazil’s economy continues to expand at a brisk pace, driving inflation that is already well beyond the official target range?

NOBODY SAW IT COMING

Confronted with such questions, officials said the central bank’s leadership believed that the economic outlook had changed so drastically in August — especially abroad — that it simply could not afford to wait until the next rate-setting meeting on October 18-19 to make a major cut in rates.

The world “has turned upside down” since July, one of the officials said.

Most independent economists are more sanguine — or at least believed the impact on rates would be more limited.

In a Reuters poll taken a week before the rate decision, all 20 analysts forecast the bank would leave the Selic unchanged. That view evolved as Rousseff and her economic team announced new budget spending goals they said would allow for interest rates to come down over time, and by the day of the decision, interest rate futures markets were pricing in roughly a 60 percent possibility of a 25 basis-point cut.

Asked how traders and economists got it so wrong, the official said the central bank’s leadership had clearly telegraphed its concern over the darker global outlook, and that anyone who paid close attention to the bank’s public statements could have anticipated the cut was coming.

The bank’s dovish stance has been somewhat undermined by the release of two economic data points since the cut.

Second-quarter gross domestic product (GDP) data released on Friday showed that economic growth is decelerating, but not to an extent that shocked Wall Street. Inflation on an annual basis continued to rise in August beyond the 6.5 percent ceiling of the bank’s target range, according to data published Tuesday.

CHALLENGE GROWS TO KEEP BUDGET IN CHECK

Officials said the third quarter is likely to be far harder on the economy. They said a GDP contraction in quarter-on-quarter terms is possible — a possibility echoed by some Wall Street firms such as Credit Suisse.

Among the evidence supporting the darker view: A central bank economic activity index that fell in June compared to May, the first such fall since 2008. A senior member of Rousseff’s economic team also cited new internal data showing that sales of motorcycles — the ultimate symbol of the consumer boom among Brazil’s emerging class — were flat in August compared to 2010 after years of double-digit growth.

Those data also suggest that Brazil’s economic slowdown is about more than just global problems: that it is also being triggered by local issues such as manufacturers struggling under the weight of an overvalued currency, and consumers who are highly indebted after years of heavy spending growth.

Tombini, the central bank chief, has been saying publicly since at least May that inflation on an annual basis would likely peak in August. Prices could even fall in coming months as the economy abruptly slows, officials said, bringing annual inflation back below 6.5 percent by year’s end.

For that to actually happen, the economy will not only need to slow, but workers must back off their requests for large annual wage increases in the double digits. Put another way: more Brazilians will have to come to come around to the view that the boom years here are over, which will take time.

Rousseff will also have to reduce fiscal pressure on the economy by following through on her commitment to limit spending through the end of the year. She may need to make additional cuts in 2012, as Finance Minister Guido Mantega told Reuters was possible last week.

Officials said Rousseff is ready for the challenge if that means that rates can fall in a meaningful way.

“People are complaining that the central bank has lost its independence,” an official said. “But the irony is that it’s really the Treasury that has lost its independence, because now if spending is not kept under control, it’s going to be very difficult (on the economy) with rates so low.”

(Editing by W Simon )

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