EU leaders edged toward consensus on a financial safety net for Greece on strict German conditions ahead of a key summit Thursday after the European Central Bank threw Athens a major reprieve on funding rules.
The Greek debt crisis has shaken the credibility of the 16-nation euro zone and European leaders were under intense pressure to put an aid mechanism in place to reassure nervous markets and arrest a crippling rise in Greece's borrowing costs.
The chairman of the euro area finance ministers, Jean-Claude Juncker, said after preparatory talks among conservative leaders including German Chancellor Angela Merkel he was more confident than before of reaching a deal on Greece by Thursday night.
My impression was that we would find an agreement today and now I do believe it really, Juncker told Reuters.
After weeks of public divisions over whether and how to help Greece, Merkel signaled she would accept a contingency rescue plan provided the International Monetary Fund is involved and EU partners agree to toughen the bloc's budget deficit rules.
The German government will push its view that any emergency support should come from a combination of the IMF and joint bilateral help from the euro zone. But again I say, this can only be a last resort, she told parliament in Berlin.
A good European is not necessarily one who offers help quickly. A good European is one that respects the European treaties and national rights so that the stability of the euro zone is not damaged, Merkel said.
Some euro zone states, notably France, and ECB policymakers have previously opposed an IMF role, arguing that such a move would underscore the single currency area's inability to solve the deepest crisis in its 11-year existence on its own.
A German official said Merkel and French President Nicolas Sarkozy would meet privately on the sidelines of the summit to try to resolve their differences.
Greek Prime Minister George Papandreou told reporters his country would press ahead with painful austerity measures to slash a huge budget deficit regardless of what EU leaders decided at the two-day meeting.
ECB President Jean-Claude Trichet offered some good news to Athens, announcing that the central bank would extend looser collateral rules, which were due to expire at the end of this year, into 2011.
Greece was at risk of having its bonds rejected as collateral for refinancing with the expiry of the relaxed rules, a step that risked triggering an even deeper liquidity crunch.
It is the ECB's contribution to the resolution of the Greek crisis, said Nomura economist Laurent Bilke. It is also a message to the EU that Greece deserves support.
Spreads between Greek bond yields and German benchmarks narrowed slightly after Trichet's announcement.
Athens is still saddled with borrowing costs more than double those of Germany and must borrow some 16 billion euros between April 20 and May 23 alone to refinance maturing debt.
The new Socialist government revealed on taking office last October that the budget deficit was more than twice the previous estimate, shocking investors who dumped Greek debt.
Greece says a standby aid package from the EU would reassure credit markets and avert the need for it to request aid.
Greece is determined to deal with its own problems, put its own house in order, said Papandreou. We have already ... embarked on a journey of major radical reform.
Whatever the decision taken today, Greece will move ahead in a positive manner and in the right direction, he said.
CONSENSUS FORMING ON IMF-EU AID
Juncker said he expected the solution would involve both IMF and bilateral European aid.
Swedish Prime Minister Fredrik Reinfeldt said Stockholm was prepared to offer bilateral aid to Greece if the IMF was involved, even though Sweden is not a member the euro zone.
Germany, Europe's biggest economy, faces overwhelming public opposition to any bailout for Greece and fears that direct euro zone assistance would face legal challenges at home.
Merkel had an extra incentive to stick to her guns ahead of a crucial state election on May 9, where defeat would erase her center-right majority in the upper house of parliament.
As a condition, she made clear that EU rules must be rewritten to provide harsher punishment for deficit sinners and give enhanced surveillance powers to the EU statistics agency.
The German people gave up the deutschmark based on their faith in a stable euro. This faith, and this is the view of the entire German government, cannot be disappointed under any circumstances, she said.
Without a fallback mechanism, EU leaders fear Greece's debt problems could spread to other countries in the euro zone including Portugal, Spain or Italy.
Fitch downgraded Portugal's sovereign debt rating by one notch to AA- Wednesday. The Portuguese opposition cleared the way for parliament to approve the government's austerity budget later Thursday by saying it would abstain.