EU leaders appeared to be nearing consensus on an aid mechanism for Greece based on strict German terms before a high-stakes summit on Thursday and Athens won a reprieve when the European Central Bank extended looser funding rules.
The Greek debt crisis has shaken the credibility of the 16-nation euro zone and leaders are under intense pressure to put an aid system in place that would reassure nervous markets and arrest a crippling rise in Greece's borrowing costs.
But sharp divisions exist within the single currency bloc about how to help Greece, with Germany resisting calls for direct euro zone support for fear this would violate EU rules and encourage fiscal profligacy in the future.
Speaking in parliament before the start of the summit, Chancellor Angela Merkel said she was not against aid for Greece as a last resort, but made clear any agreement had to be on strict German terms and involve the International Monetary Fund.
At the summit ... 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, Merkel said.
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, she said.
Some members of the euro zone and prominent members of the ECB are dead-set against an IMF role, fearing such a move would only underscore the bloc's inability to solve the deepest crisis in its 11-year existence on its own.
Greek Prime Minister George Papandreou told reporters in Brussels that his country would press ahead with painful austerity measures meant to rein in a creaking budget deficit regardless of what EU leaders decided at the two-day meeting.
Before Merkel spoke, ECB President Jean-Claude Trichet offered some good news to Athens, announcing 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 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.
Athens revealed a huge budget deficit last October, shocking investors who sent Greek bond yields soaring. Greece says a standby aid package from the EU would reassure nervous financial markets and preclude the need for it to accept 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
Jean-Claude Juncker, head of the Eurogroup of euro zone finance ministers, said he expected a solution for Greece at the summit that would involve IMF and bilateral European aid.
I believe that we will have a mixed solution. We have come together to get a solution, he said.
Arriving in Brussels, Swedish premier Fredrik Reinfeldt said Stockholm was prepared to offer bilateral aid to Greece if the IMF was involved, although it is not part of the euro zone.
France has resisted any role for the Fund, saying it would be a political humiliation, but diplomats said Paris now seemed willing reluctantly to concede a role for the IMF as the price for securing German backing for a rescue mechanism.
Germany, Europe's biggest economy, faces public opposition to any bailout for Greece and fears direct euro-zone assistance would face legal challenges at home.
Merkel has 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, Merkel 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.
EU leaders are concerned Greece's debt-servicing 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- on Wednesday. The Portuguese parliament was due to vote later on a resolution of support for the government's austerity programme.