Greece's cabinet approved a sweeping new austerity program on Wednesday, the third in as many months, to rein in a bulging budget deficit and secure European financial support, a government source said.

Measures which will yield 4.8 billion euros ($6.5 billion) have been decided, the source, who took part in the cabinet meeting, said. Half will be from spending cuts and another 50 percent from tax increases.

The measures include an increase of value added tax by 2 percentage points to 21 percent, cutting public sector salary bonuses by 30 percent and freezing state-funded pensions this year, the source said.

Prime Minister George Papandreou told the cabinet that if the European Union did not provide financial support now, Greece had the option of turning to the International Monetary Fund, a minister who attended the meeting said.

Speaking to members of his PASOK party on Tuesday, Papandreou compared his country's fiscal crisis to a war and said he would have to take harsh and possibly unfair measures.

All of Europe would be threatened, he said, if Greece failed to take brave decisions to cut a 300 billion euro debt mountain, equivalent to 125 percent of the country's annual output.

The euro rose on foreign exchange markets on the news and Greece's borrowing costs fell further, with the risk premium on Greek 10-year bonds over benchmark German bunds at 291 basis points, the lowest since early February.

The relief was evident in the money markets once Greece announced its additional austerity measures. This ... increases their chance of navigating through these troubles, said Peter Chatwell, rate strategist at Credit Agricole CIB.


The main public sector trade union, which has called a strike for March 16, vowed to fight the new measures.

We will be on the streets with all our might. I am afraid there will be a social explosion, its general secretary, Ilias Iliopoulos, told Reuters. People will start going hungry soon.

About 500 pensioners rallied in central Athens and marched to the finance ministry in a first protest against the new measures. Civil servants also planned an anti-austerity demonstration outside the ministry.

Athens taxi drivers were on strike and the communist trade union called a protest rally in the capital's central Syntagma square later in the day. Opinion polls suggest the government retains majority public support for its austerity plans.

Papandreou is due to travel to Berlin on Friday to meet German Chancellor Angela Merkel, who had demanded additional fiscal steps from Greece before considering any European financial safety net for the euro zone's weakest economy.

Economists estimate the pay cuts could generate savings of about 0.7 billion euros and an increase in VAT tax by two percentage points may generate additional revenue of about 1.4 billion euros or 0.6 percent of GDP.

The government received a small boost earlier from credit ratings agency Standard & Poor's when the debt watchdog's global head of sovereign ratings said he was less pessimistic about the Greek crisis than financial markets were.

The political standing of this government is still very high, if recent polls are to be believed, S&P's David Beers told Reuters in Singapore.

S&P rates Greece BBB+, two notches above the lowest investment grade, with a negative outlook. If Moody's, the last ratings agency that still gives Greece an A grade, follows suit, Greek government bonds would no longer be eligible as collateral for European Central Bank lending from the end of this year.


ECB governing council member Ewald Nowotny challenged that situation on Tuesday, without saying how it could be changed.

The fate of Greece, and if you are going to be more dramatic, the fate of Europe, depends on the judgment of one rating agency. That is an unacceptable situation, the Austrian central banker said at a panel discussion in Vienna.

European government sources have said Germany and France are working on contingency plans under which state-owned financial institutions would directly purchase billions of euros in Greek bonds or offer guarantees to commercial banks that bought them.

In his speech on Tuesday, Papandreou said Greeks should not be lulled into thinking a government default was a remote nightmare scenario, saying new holes in the budget deficit were appearing on a daily basis.

Although market pressure on Greece has eased in recent days, a Reuters poll of economists showed on Tuesday that skepticism about the government's ability to meet a goal to slash its deficit by four percentage points this year still runs deep.

Only 18 of 47 respondents said they believed Athens would meet that target, with most predicting a slow burn scenario through 2010 in which the government makes only limited progress in reducing the deficit.

One Greek celebrity offered a symbolic sacrifice. Singer Nana Mouskouri, 75, was quoted by German magazine Der Spiegel as saying she would give up her pension as a former Socialist member of the European Parliament to the Greek state.

(Additional reporting by George Georgiopoulos and Dina Kyriakidou in Athens, George Matlock in London and Boris Groendahl in Vienna, Writing by Paul Taylor; Editing by Ruth Pitchford)

($1=.7395 Euro)