Markets took a tumble on Thursday on fresh worries about the Greek sovereign debt crisis while European policy makers were urged to come up with a credible plan to restructure the country's debt.
Violent clashes between protestors and police in Athens on Wednesday led Greek Prime Minister George Papandreou to offer to resign.
Papandreou will reshuffle his cabinet on Thursday and put his new government to a vote of confidence in the Greek parliament as he attempts to settle nerves about the country’s ability to push through a five year campaign of tax hikes, spending cuts of around 28 billion euro ($40.5 billion) and the privatization of state assets.
The austerity measures are necessary in order for Athens to receive 12 billion euros ($16.9 billion) of additional aid from the European Union (EU) and International Monetary Fund (IMF) in order to pay back sovereign debt that matures at the end of July.
Economic and Monetary Affairs Commissioner Olli Rehn said he was sure euro zone ministers will decide to release the aid.
"I am confident that next Sunday, the Eurogroup will be able to decide on the disbursement of the fifth tranche of the loans for Greece in early July. And I trust that we will also be able to conclude the pending review, in agreement with the IMF," Rehn said in a statement.
Analysts told CNBC.com that policy makers were helping to exacerbate the situation and called on them to resolve matters quickly when they meet on 24 June, rather than let things worsen.
But at the same time they suggested the markets were due a correction and that volatility would continue regardless of Greece’s ability to pay its debts.
"The longer it takes to sort out Greece the more damaging it will be. Asset prices will move to the downside and CDS prices to the upside until the situation is resolved,” Manoj Ladwa, a senior trader at ETX Capital told CNBC.com.
But Ladwa added many investors were simply wondering where any upside in stock prices was going to come from.
“We were due a clear out,” he said. “We’ve pretty much hit the top in terms of corporate earnings and there’s the end of QE2 on the horizon in the US to consider as well.”
Moorad Choudhry, managing director, head of business treasury, Global banking & markets at Royal Bank of Scotland told CNBC.com he believed the markets were reacting to several factors and not just the Greek crisis.
“The markets are volatile today for a number of reasons of which the euro zone is just one but I don’t expect any significant announcement," Choudhry added. "They have put off this additional aid package because I guess they can’t agree amongst themselves at the political level but it is only a matter of time before we see some sort of default, technical default or restructuring in the Greek space.”
What is creating concern is the nature of a default if it were to happen, with the result being that the spread on five-year credit default swaps (CDS) widened by 150 basis points on Wednesday alone to record a new high of 1700.
By Thursday morning that record high had been smashed as the spread widened even further to 1850 basis points.
Two year and five-year cash bond yields were also wider on Wednesday by 100 basis points with two year yields reaching 26.76 percent. Then on Thursday morning the yield on two year bonds moved above 30 percent.
All of which pointed to a “credit event” - where any restructuring deal would trigger a payout on CDSs, analysts said.
“Ideally at the EU leadership level they would like to see some sort of restructuring that doesn’t trigger a credit event,” said Choudry.
“But whether that will happen I don’t know and that’s the issue here. We could end up with a restructuring that isn’t clear cut and no one knows where they are, which would be messy from a market point of view because the markets don’t like uncertainty."
“It really depends what the final form of any restructuring is, and to what extent it triggers a payout on the CDS market. If that’s a default then you can draw a line under it and begin to move forward but I don’t know what form it will take and no one does and that’s what is adding to the volatility and uncertainty,” he added.
Fueling that uncertainty have been the comments of several influential figures in the last 24 hours including European Central Bank (ECB) governing council director, Nout Wellink, who told Dutch newspaper Het Financieele Dagblad a new Greek aid package would carry so many uncertainties and risks that a doubling in the EU bail-out fund would be necessary to take into account the contagion risk for both Ireland and Portugal.
"If you take these risks, you need to build a safety net," Wellink said. "It should go to 1,500 billion euros and there should be more flexibility in how the money can be spent."
Meanwhile, Reuters reported a special advisor to the IMF's managing director, Zhu Min as saying: "I am concerned the situation has changed very dramatically in the past 24 hours."
Bank Shares Fare Badly
Unsurprisingly European bank shares faired badly in morning trade on Thursday with French and Germany banks falling over fears of their exposure to Greek sovereign debt. British banks also fell Thursday.
“European banks do hold Greek sovereign debt on their balance sheets so they will suffer a loss and write off capital," Choudhry said.
"Some banks that hold these bonds have already marked them to the market level and so they wouldn’t be suffering a new loss but banks that hold such assets in a banking book – a non fair value book will take a capital loss and so I guess the ECB and other European officials are worried about the extent of that capital loss,” he added.
Ladwa added that the markets simply still did not know the fully level of exposure of French and German banks to sovereign debt, which explained the bank shares sell off.
However, Choudhry said, in reality the situation remained largely unchanged for Europe. While Thursday was going to be a bad day for the markets, the euro zone should – at least in theory – be able to cope with a Greek debt default largely because its economic contribution to the wider euro zone amounted to only around six percent of GDP.
What remain far bigger concerns are the risk of contagion from Greece to Portugal and Ireland and more broadly, thought less likely, Spain. Choudhry suggested that while Europe could cope with one member country defaulting further, two or three could bring down the euro entirely.