Germany signaled for the first time on Tuesday that it may accept European financial aid for Greece as a last resort, but demanded that euro zone partners agree to negotiate tougher budget discipline rules.
A senior German official spelled out Berlin's conditions for any aid mechanism ahead of an EU summit starting on Thursday: Greece would have to be unable to access credit markets; the IMF would have to contribute to any rescue; European Union states would have to agree to negotiate "additional instruments" to enforce budget discipline, beyond existing rules that failed to prevent Athens running up huge debts and deficits that have shaken the euro zone.
"The condition for action, as a last resort, is that Greece's financing on the capital markets is exhausted," the official said.
"Furthermore, it would be necessary for the International Monetary Fund to provide a substantial contribution," he said, stressing there will be no decision on actual aid at the summit.
European diplomats said France and Germany, co-founders of the single currency, were working on a joint position on Greece for the summit, including a possible role for the IMF, which Paris has rejected as anathema inside the euro family.
"The message from Berlin is crystal clear really, which is that Greece still needs to continue not just with consolidation but to test the markets out and if necessary use the IMF," said Julian Callow, Chief European Economist at Barclays Capital.
"The implication is that Germany will support Greece only if the IMF channel does not deliver," he said.
France and Spain called for a special meeting of leaders of the 16 nations that share the euro zone ahead of the regular two-day EU summit which opens on Thursday afternoon.
The euro group has held only one such summit previously, at the height of the global financial crisis in October 2008.
Greek Finance Minister George Papaconstantinou said he expected a positive outcome and was encouraged by comments from EU institutions on ways to support Greece's efforts to cut its giant budget deficit and public debt.
"Based on these statements, we expect a positive result on Thursday," he told an investment conference in Athens.
"There must be a political mechanism to ensure the stability of the euro zone and support the efforts made by every country," he said, adding that data for the first two months of 2010 show Greek revenues rose and spending fell sharply.
German Chancellor Angela Merkel faces massive public opposition to any bailout ahead of a regional election in May in which her center-right coalition's upper house majority is at stake, and has said there will be no talk of aid at the summit.
The risk premium that investors charge for holding Greek debt rather than German bonds narrowed to 327 basis points from around 344 at Monday's settlement close on hopes of a deal, although it was still above last week's levels.
Greece needs to refinance some 16 billion euros in maturing debt between April 20 and May 23 and is hoping that a public display of an EU emergency support mechanism, which would not need to be activated, will be enough to force down the cost.
The crisis over Greece's debt, expected to hit 120 percent of national output this year, and its budget deficit, which reached 12.9 percent of GDP last year, has shaken confidence in the euro single currency.
German Economics Minister Rainer Bruederle said a stable euro was in the national interest, adding that the single currency's image should not be damaged.
German coalition leaders meeting in Berlin voiced full support for Merkel's tough stance towards Greece.
Hans-Peter Friedrich, floor leader of the Bavarian Christian Social Union, sister party of her Christian Democrats, said it was great to see the chancellor standing her ground "and not letting herself be forced into any concessions."
European Commission President Jose Manuel Barroso, usually cautious with the EU's most powerful leaders, has publicly challenged Merkel to agree this week on a support mechanism for Greece, warning that continued uncertainty would harm the euro.
Diplomats said European Council President Herman Van Rompuy, who will chair Thursday's summit, was working for a compromise that would satisfy Merkel and prevent the bloc's divisions over Greece spilling into the open again and destabilizing markets.
The nominee for vice-president of the European Central Bank, Vitor Constancio, pointed to a possible solution, telling a European Parliament hearing that giving Greece credit would not be an illegal bailout if the loans were not subsidized.
Austrian Finance Minister Josef Proell warned in a newspaper interview that failure to help Greece could have a "domino effect" on neighboring central and eastern European countries where his country has big financial interests.
Portugal's finance minister warned parliament that unless it supported the government's long-term budget consolidation plan, Lisbon too might have difficulty finding funding in the markets.
Papaconstantinou stressed that Greece was not bankrupt and was not going to the EU summit as a beggar.
"We want to play by euro zone rules. Greece has full access to financial markets as it proved with its recent 10-year bond sale. Obviously, we would like the spreads to fall but I believe this will gradually happen as the stability program is implemented," he said.
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