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 to stop contagion spreading 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.
Worsening political tensions between Prime Minister Silvio Berlusconi and his Finance Minister Giulio Tremonti have caused markets to focus on Italy's shaky banks and chances its budget deal could stumble, and to look afresh at Spain, the euro zone's fourth largest economy.
Willem Buiter, chief economist at Citi and a former UK central banker, said there now was a clear danger of the debt crisis spreading 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.
Sucking Italy and Spain into the vortex would be hugely costly. He estimated that the European rescue fund would have to be expanded to a 2 trillion euro ($2.8 trillion) to help out struggling euro-zone countries if they are locked out of capital markets.
The International Monetary Fund called on Italy to take decisive steps to cut its fiscal deficit below 3 percent by 2012 and said its medium-term package is an important step.
Underscoring the difficulty in bringing the crisis under control, Moody's Investors Service downgraded debt of Ireland to junk status on Tuesday, warning that nation may need a second bailout before it can sell bonds to investors.
The prospect that European policymakers will require the private sector to share the burden of any future bailouts, a bone of contention in EU leaders' talks, weighed on Moody's decision, since that would drive up borrowing costs, the agency said.
Increasingly, EU leaders are looking at how to restructure Greece's debt, but ratings agencies warn that the measures would amount to default. Investors fear that a Greek default would ripple through markets, pushing up sovereign debt yields and weakening Europe's banking system -- requiring more bank bailouts that would stretch public finances to breaking point.
A French government source said Paris was in favor of another summit, 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 creditor 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.
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 Institute of International Finance, the lobby group representing private creditors, said the EU and IMF needed to deliver a plan for Greece, including a debt buyback, within days to avoid markets spinning out of control.
The increased likelihood of some form of default, and a lukewarm response from the IMF, hit European bank stocks and debt markets and propelled the euro sharply lower against the dollar though markets later settled down.
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.
In Rome, Berlusconi tried to calm fears Italy could be swept into full-scale crisis, pledging to accelerate debt-cutting measures and run a primary surplus this year.
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.