Merrill Lynch: The inconvenient truth about Greece

As it explains, "In the context of the current negotiations to cover a financing gap in the Greek program and IMF demands for official debt relief in Greece, we discuss the issues involved. Our base case is that the current dynamics of Greek debt/growth are unsustainable but we conclude that we don't expect an official sector haircut but extension of maturities and some reduction in interest rates".

The bank believes that if long-term growth performance does not stand to expectations and comes in line with its projections, and reforms are delayed or do not deliver the expected effects, 100 billion euro debt relief could be needed, which would require not only lower EFSF rates, but also a substantial extension of maturity.

However, fixing the rate charged on the EFSF loans is likely to be very difficult politically, because it would mean that the EFSF would face losses when its market funding rate increases, depending on market conditions.

According to the report, making debt relief conditional on specific reforms, rather than quarterly program reviews, could help address moral hazard concerns and increase the chances for a sustained recovery of the Greek economy.

According to BofA Merrill Lynch, if the Greek debt proves to be unsustainable, and assuming the program is on track, Europe may have no other choice but to agree on a partial debt relief.