Athens/Brussels: International lenders dangled a lifeline to save Greece from defaulting next month as Prime Minister George Papandreou faced down rebels in his socialist party against EU/IMF-ordained austerity measures.

The political drama in Athens, where mass street protests turned violent and efforts to form a national unity government collapsed on Wednesday, rocked financial markets already spooked by dithering in Europe over a second bailout for Greece.

“Our response to the challenges we face is stability and to stay on our course of reforms," Papandreou told a parliamentary caucus meeting called by critics of his austerity policies.

The prime minister, who was expected to reshuffle his cabinet later on Thursday, also said he would continue to seek wider political consensus despite the failure of talks with the conservative opposition in which he offered to step aside.

The euro fell to a record low against the Swiss franc and slid against the dollar and the yen on Thursday as investors fled to safe-haven assets on mounting concerns that Greece’s problem are far from resolution.

There were also some signs on money markets of growing tension in inter-bank lending, as occurred when the Greek debt crisis erupted early last year.

In a statement intended to soothe markets, the European Union’s top economic official, Olli Rehn, said he expected the EU and the International Monetary Fund to release a crucial €12 billion loan tranche in early July to keep Athens afloat.

Rehn acknowledged it would take longer to put together a second rescue package for the heavily indebted state, due to differences over how to make private investors share the burden, but he called for decisions by mid-July rather than leaving the issue until September, as EU paymaster Germany is suggesting.

“I am confident that next Sunday, the Eurogroup will be able to decide on the disbursement of the fifth tranche of loans for Greece in early July. And I trust that we will be able to conclude the pending review in agreement with the IMF," he said.

An IMF spokeswoman said continued financial support depended on Athens adopting agreed economic policy reforms and approval by the Fund’s board, where emerging nations are growing critical of pouring more money into Europe.

“Progress is being made in the discussions to ensure the full financing of the programme, and we anticipate a positive outcome on this at the next Eurogroup meeting," she said.

Battered by strikes, protests and a string of resignations in his PASOK party, Papandreou vowed to drive through a draconian programme of spending cuts, tax rises and state asset sell-offs to meet the EU/IMF conditions.

Finance minister George Papaconstantinou, who is trusted by global lenders and investors, may be sacrificed due to the deep unpopularity of the austerity plan, government sources said.

The IMF had made release of the aid tranche due on 29 June conditional on euro zone states agreeing to meet Greece’s funding needs for the next 12 months. But several sources said the global lender had now signalled that a political pledge of future funding would be enough.

Market jitters

Greek bond prices fell to record lows and the cost of insuring Greek debt against default soared to an all-time peak. The risk premium on the bonds of several other euro zone sovereigns - including Spain and Italy - also rose as investors fled to safe-haven German bunds.

In the latest warning from the European Central Bank, policymaker Yves Mersch said a “disorderly insolvency" of a euro zone state would have devastating effects for the whole currency bloc and “a new financial crisis would be more than likely".

Ireland’s finance minister added to market jitters by saying on Wednesday that Dublin would seek to impose losses on senior bondholders in nationalised Anglo Irish Bank and Irish Nationwide Building Society.

The European Commission, which has opposed such a move in the past, said it had not received any proposal from Ireland, and Irish Deputy Prime Minister Eamon Gilmore said Dublin had yet to raise the issue with the ECB, whose approval would be crucial since it provides the only funds available to Anglo.

Trade in European money markets showed growing fear that banks may stop lending to each other because of their exposure to Greece, though tensions were not as severe as during the global credit crisis of 2007-2009, when the market froze up.

The one-year euro/dollar currency basis swap spread, which rises when banks become unwilling to supply dollars to each other, widened to 37 basis points, its widest since February, from around 23 bps on Wednesday.

It hit 55 bps when the Greek crisis erupted early last year, and 120 bps after Lehman Brothers collapsed in 2008.

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

But two sources briefed by the German government said Berlin wanted to postpone agreement on a new €120 billion programme, including 30 billion in privatisation proceeds, until September due to disputes over how to involve private investors.

Backed by the Netherlands and Finland, Germany wants a “voluntary" debt swap in which bondholders would be given new bonds with a seven-year maturity, but credit rating agencies have warned they would treat that as a selective default.

That could prompt the European Central Bank to refuse to accept Greek bonds as collateral, depriving Greek banks of vital ECB liquidity on which it is totally dependent.

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

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

ECB policymaker Lorenzo Bini Smaghi said the ECB would not break its own rules, noting that the EU treaty barred accepting as collateral “bonds from a state that is considered to have defaulted".