Euro zone finance ministers opened the door to some form of Greek default, promising cheaper loans and longer debt maturities, but markets seized on the lack of a deadline to heap more pressure on Italy and Spain.
For the first time, the ministers declined to rule out the possibility of a selective default by Greece to make its debt mountain more sustainable, despite the European Central Bank's vehement opposition to such a move.
"It is not excluded any more. Obviously the ECB has stated in the statement that it did stick to its position, but the 17 ministers did not exclude it any more so we have more options, a broader scope to work with," Dutch Finance Minister Jan Kees de Jager told reporters on Tuesday.
After eight hours of talks on Monday, ministers from the 17 euro zone countries promised new steps "shortly." Participants said both a buy-back of Greek debt on the secondary market and a German proposal for a bond swap for longer maturities were under consideration after a complex French plan to roll over bonds made no headway.
But disagreement about the detailed steps barred them from taking immediate action, prompting investors to take fright.
The cost of insuring against a default in Spain, Portugal and Greece hit a record high and 10-year bond yields in Italy, the euro zone's third-largest economy, shot above six percent for the first time since 1997, well above the level which bankers say will start putting heavy pressure on its finances. European bank shares slid to a two-year low.
If Italy needed a bailout, the euro zone's existing rescue mechanism, the EFSF, would have insufficient funds to help.
Euro zone officials are hoping concrete decisions on Greece can be taken at another meeting later this month and ease pressure on all the bloc's high debtors.
But despite the market turmoil, Germany's finance minister said there was no hurry. "We have time on Greece. The next tranche is due in September," Wolfgang Schaeuble told Deutschlandfunk radio.
That lack of haste prompted stern criticism from Greece's prime minister but the finance ministers did hint at the prospect of more fundamental steps to come.
"Ministers stand ready to adopt further measures that will improve the euro area's systemic capacity to resist contagion risk, including enhancing the flexibility and the scope of the EFSF, lengthening the maturities of the loans and lowering the interest rates, including through a collateral arrangement where appropriate," they said in a statement.
The euro fell to a four-month low against the dollar following the inconclusive meeting and after IMF Managing Director Christine Lagarde said the lender and its EU partners were not yet ready to discuss terms for a second Greek bailout. "Nothing should be taken for granted," she told reporters in Washington.
The Italian slide was triggered last week by concerns that Prime Minister Silvio Berlusconi was trying to undermine and perhaps remove Finance Minister Giulio Tremonti, seen as the guarantor of fiscal prudence in Rome.
Italy has the second-biggest per-capita debt after Greece but has avoided the fate of Greece, Ireland and Portugal, which were forced to seek EU/IMF bailouts, because it has a low budget deficit and a liquid bond market largely in domestic hands.
The ministers gave no indication that they had broken a stalemate over how to make banks, insurers and other funds share the cost of additional funding for Athens.
Germany and others want the private sector to provide around 30 billion euros ($41.98 billion) in a new package for Greece that could total 110 billion euros.
But one national official said they were moving closer to sharing the cost of easing Greece's debt burden with investors even if credit ratings agencies were to declare a default.
"I would read this as an acknowledgement by the member states that a selective default is going to be difficult to avoid. It removes an obstacle to the participation of the private sector," the official said, speaking on condition of anonymity.
Ministers tasked a working group to propose ways to finance a new multi-year program for Greece, reduce the cost of servicing its 340 billion euro debt — nearly 160 percent of annual output — and improving its sustainability.
Euro group sources said ministers were likely to meet again before the end of July to try to clinch an agreement.
Jean-Claude Juncker, chairman of the Eurogroup, told a news conference there would clearly be private-sector involvement in the new bailout and talks on how to do this would be concluded "as soon as possible." In a withering open letter to Juncker, Greek Prime Minister George Papandreou said European partners had acted too slowly to stem the crisis while creating a "cacophony" that had ultimately put domestic politics before the common currency.
"Crunch time has arrived and there is no room for indecisiveness and errors such as taking decisions that in the end prove 'too little, too late' to convince the markets we are serious; (and) making compromises that satisfy our internal political 'red lines' that in the end substitute tactical politics for sound management of the crisis," he wrote.
Papandreou rejected a French alternative for private-sector creditors to roll over around 70 percent of their Greek debt into 30-year bonds and other AAA-rated securities as "too expensive, too little and too dangerous." As the French plan has faltered, Berlin has revived a proposal to swap Greek bonds for longer-dated debt that would extend maturities by seven years.
However, the ministers noted that the ECB had reaffirmed that any solution must avoid a credit event or a selective default.
Both a buyback and a bond swap would likely be regarded by ratings agencies as a default, or at best a selective default, which could have profound repercussions for financial markets.
In a buy-back, the bloc's European Financial Stability Facility (EFSF) bailout fund might buy Greek bonds from the market, or lend Greece money to do so.
Officials say that would require changes to EFSF's rules which would need the backing of national parliaments — a further potential obstacle.
Policymakers have been seized with a new sense of urgency after Italy came under market attack last week, fearing any further delay in putting together a second Greek package could poison investor confidence in weak economies around the region.
Lagarde said Italy needed to boost economic growth to help restore confidence, adding the IMF had to be alert to any significant difficulties arising from the effects of contagion.
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