Newly appointed Finance minister Evangelos Venizelos addresses the audience during a handover ceremony in Athens June 17, 2011. [Photo/Agencies]

BOND MARKETS RATTLED

Battered by strikes, protests and a string of resignations in his PASOK party, Papandreou has vowed to drive through his unpopular reform programme for the sake of stability in Greece.

He removed the environment and labour ministers whom EU and IMF officials say have resisted attempts to speed up privatisation and loosen labour market regulation.

The political drama in Athens, where mass street protests turned violent and efforts to form a national unity government collapsed on Wednesday, and the splits in the EU kept bond markets see-sawing on Friday.

The yield on 10-year Greek government bonds spiked to a record high of 18.9 percent just before the reshuffle was announced, and the cost of insuring Greek debt against default also hit a new all-time peak. Both fell back later.

In the latest warning from the ECB, policymaker Yves Mersch said a "disorderly insolvency" would have devastating effects for the whole currency bloc and "a new financial crisis would be more than likely".

The European Union's top economic official, Olli Rehn, told a Finnish newspaper he was sure the EU and the International Monetary Fund would release a crucial 12 billion euro loan tranche in early July to keep Athens from defaulting.

China weighed in, saying it had a vital interest in the euro zone overcoming its debt woes and had increased its holdings of euro debt, but gave no figures or timeframe.

"Whether the European economy can recover and whether some European economies can overcome their hardships and escape crisis, is vitally important for us," Vice Foreign Minister Fu Ying told a media briefing in Beijing.

Rehn said he expected euro zone finance ministers to take decisions on a successor programme for Greece on July 11.

Both Sarkozy and Merkel dismissed reports that Berlin wanted to postpone agreement on a new 120 billion euro programme, including 30 billion in privatisation proceeds, until September.

"We want to go as quickly as possible without fixing a date," Sarkozy said. "Since September is not as quickly as possible and we may have other concerns in August and we are in the second half of June, you see what I mean."

For her part, Merkel backed away from a Berlin debt swap initiative in which bondholders would be given new Greek bonds with a seven-year maturity. Credit rating agencies have warned they would treat that as a form of default.

The European Commission, the ECB and France have been pressing a softer form of private sector involvement under which banks would agree to roll over Greek bonds as they mature and are redeemed.

Merkel said a 2009 agreement by banks to voluntarily maintain their exposures in central Europe at the height of the financial crisis, known as the Vienna Initiative, was a "good foundation" for a Greek deal.

"I believe that we can move forward on this basis," she said.

Sarkozy said ECB backing was crucial for any deal. Any form of default could have prompted it to refuse to accept Greek bonds as collateral, depriving Greek banks of vital liquidity on which it is totally dependent.

Fitch Ratings appeared to open the door to a possible compromise on Wednesday by saying that while it would treat a rollover as a "restrictive default", it would keep Greek bonds rated at CCC, just above default status.