European Union leaders are poised to hold an emergency summit after finance ministers acknowledged for the first time that some form of Greek default may be needed to cut Athens' debts and stop contagion to Italy and Spain.
"There will be an extra summit this Friday," a senior euro zone diplomat told Reuters, suggesting policymakers have been seized with a new sense of urgency after markets started targeting Italian assets.
A French government source said Paris was in favor, although the timing was not yet fixed, and in Spain, European Council President Herman Van Rompuy said he had not ruled out a meeting.
Earlier, Germany's finance minister had said a second Greek rescue package could wait until September after euro zone finance ministers effectively accepted that private sector involvement meant a selective debt default was likely, despite the European Central Bank's vehement opposition to such a move.
"We have managed to break the knot, a very difficult knot," Dutch Finance Minister Jan Kees de Jager told reporters as he arrived for a second day of talks.
Asked about whether a selective default was now likely, he replied: "It is not excluded any more.
Obviously the European Central Bank has stated in the statement that it did stick to its position, but the 17 (euro zone) ministers did not exclude it any more so we have more options, a broader scope."
Participants said 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.
Both would likely be regarded by ratings agencies as a default, or at best a selective default, which although it would not necessarily cover all Greek debt and could be lifted quickly, would have major repercussions for financial markets.
The increased likelihood of some form of default, and a lukewarm response from the IMF, sent European bank stocks and debt markets into a spin and propelled the euro sharply lower against the dollar although markets settled later.
Ten-year bond yields in Italy, the euro zone's third-largest economy, shot above six percent for the first time since 1997 but then subsided to around 5.7 percent, still at a level which bankers say will put heavy pressure on finances.
Borrowing costs at an Italian 12-month bill sale surged to their highest since the 2008 financial crisis, putting a Thursday bond auction firmly in focus.
There is now acute concern about contagion to Italy, where political tensions between Prime Minister Silvio Berlusconi and Finance Minister Giulio Tremonti have exacerbated concerns, and to Spain, the euro zone's fourth largest economy.
Willem Buiter, chief economist at Citi and a former UK central banker, said there was clear spread beyond Greece, Ireland and Portugal, the three nations bailed out so far.
"We're talking a game changer here, a systemic crisis," he said. "This is existential for the euro area and the EU."
The euro fell to a four-month low against the dollar before recovering, in part because 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.
While the finance ministers were not explicit about how they planned to tackle Greece's debt, saying only that proposals would be discussed "shortly," they acknowledged that the debt pile — which stands at around 160 percent of GDP — had to be reduced.
"We stress the need to make Greek debt more sustainable," Jean-Claude Junker, the chairman of the Eurogroup of finance ministers, said after more than eight hours of talks on Monday.
Economists regarded Junker's words and the comments from other finance ministers as a fundamental shift, although it remains unclear what specific steps will be taken.
"The euro area now seems to be moving more explicitly towards debt relief via EFSF-funded purchases of secondary market debt," JPMorgan economist David Mackie wrote in a research note, referring to the euro zone's 440 billion euro emergency loan fund, which as it stands would not have enough resources to bail out Italy.
"Greece will need debt relief at some point, but it is not clear it is much of a help now. More likely the shift towards debt relief is intended as an attempt to limit contagion."
Quick Markets, Slow Decisions
The decision to call an extra leaders' summit helped counter negative market reaction to an apparent absence of hurry.
"We have time on Greece. The next tranche is due in September," German Finance Minister Wolfgang Schaeuble told Deutschland funk radio earlier on Tuesday.
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.
Despite reiterating the need to have the private sector involved in a second package for Greece, how to do it remains unresolved.
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, the Netherlands, Finland and others want the private sector to provide at least 30 billion euros ($41.98 billion) in a new package for Greece that could total 110 billion euros.
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.
In a withering open letter to Junker, 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.
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