Markets tumble as Greek government talks fail

By Dina Kyriakidou and Paul Taylor

ATHENS/PARIS (Reuters) - Attempts to form a government in Greece collapsed on Tuesday, jolting financial markets at the prospect that leftists opposed to the terms of an EU bailout could sweep to victory in a June election and tip the euro zone deeper into crisis.

The turmoil in Athens sent shock waves around other troubled members of the 17-nation European single currency area. The euro slipped below $1.28, world stocks slid and Spanish and Italian bond yields rose above the danger level of 6 percent as investors scurried for shelter in safe haven German Bunds.

The tremors from Greece, compounding worries about Spain's debt-laden banking system, ended any honeymoon for new French President Francois Hollande, thrusting the growing risks to the euro zone to the top of the agenda for his first meeting with German Chancellor Angela Merkel hours after he took office.

In his inaugural address, the Socialist president called for a European pact to revive growth and temper German-driven austerity measures, seeking to change the direction of euro zone economic policy.

"I will propose to our partners a pact that will tie the necessary reduction of our public debt to the indispensable stimulation of our economies," Hollande declared, saying Europe needed "projects, solidarity and growth".

The French leader's aircraft was struck by lightning shortly after takeoff from a military airport near Paris en route for Berlin, forcing him to turn back and take a substitute plane.

In Athens, President Karolos Papoulias abandoned efforts to broker a compromise on a cabinet of technocrats to steer the country away from bankruptcy, nine days after an inconclusive general election. A caretaker government will now be formed pending a new vote probably in mid-June.

"We resisted in every way," said Alexis Tsipras, leader of the hard-left SYRIZA party, which surged to second place in last week's election on an anti-austerity platform and blocked any deal with pro-bailout mainstream parties.

"We made the decision to not betray your hopes and your expectations," said Tsipras, emboldened by opinion polls showing his party could top the poll in a second vote. "Now it's time to complete it: We will consign in the dustbin of history all the spent forces of the past.

Euro zone finance ministers dismissed talk of Greece leaving the single currency area as "propaganda and nonsense" on Monday. But with hostility to EU/IMF-imposed austerity rising in Greece, speculation about a possible state bankruptcy and euro exit is rattling financial markets and won't go away.

IMF chief Christine Lagarde said it was important to be technically prepared for the possibility of Greece leaving the euro zone, warning that such a move would be "quite messy" with risks to growth, trade and financial markets.

Finnish Prime Minister Jyrki Katainen openly discussed the prospect, telling broadcaster MTV3: "If Greece were to leave the euro it would probably not cause a significant financial crisis that would have happened a couple of years ago.

"But on the other hand, we would have other problems. What kind of impact would it have on European economic development, on Spain's, Italy's economies, would market begin to speculate about other euro countries leaving? Naturally it would have an impact on the stability of Greek society."

MORE TIME?

Averting an immediate default, Greece made a key payment to bondholders who rejected an earlier debt exchange, a move likely to upset the vast majority of creditors who accepted just cents on the euro in a historic bond swap in March.

The outgoing government opted to pay 435 million euros ($552 million) of a May 15 bond to investors who had refused to exchange their debt, despite having insisted that those who rejected the swap would get nothing.

Sworn in with all the pomp of the French Republic, Hollande won support from Germany's opposition Social Democrats (SPD), who vowed to use their parliamentary blocking power to delay ratifying a European budget discipline treaty until Merkel accepts accompanying measures to boost growth and jobs.

Hollande's inauguration with military honors, capped by an open-topped motorcade ride up the Champs Elysees to the Arc de Triomphe in a torrential downpour, marks a potential turning point in the euro zone's debt crisis.

EU officials hope his election will revive proposals for radical steps to overcome the debt crisis such as issuing joint euro zone bonds, which Merkel has so far blocked.

Some policymakers believe it could also lead to heavily indebted member states that are in the grip of a recession being given more time to meet their EU budget balancing targets.

Markets and policymakers are watching the dialogue between the conservative German chancellor and the centre-left French leader for signs that they can overcome their differences on Merkel's drive for austerity and lead the euro zone together.

In Berlin, the Social Democrats, invigorated by their victory over Merkel's Christian Democrats (CDU) in a major regional election on Sunday, said growth measures must go beyond the structural economic reforms advocated by the chancellor.

"That is not our definition of growth nor that of the Socialists in France," said SPD Chairman Sigmar Gabriel.

A senior Merkel ally, CDU parliamentary whip Peter Altmaier, said that while he expected no concrete decisions to be taken at the first Merkel-Hollande meeting, he was confident the euro zone's two most powerful economies would reach a joint position on growth measures in time for an EU summit next month.

"It is important that we study each others' proposals. But I am sure that we will be able to agree a common Franco-German approach by the end of June at the latest," Altmaier told Reuters in an interview.

Despite the SPD's threat, Altmaier said he expected the German parliament to approve the European fiscal compact before the summer recess, which requires some opposition votes to provide the necessary two-thirds majority.

"HOMER" AFTER "MERKOZY"?

Merkel and former French President Nicolas Sarkozy, who left office on Tuesday, had dominated euro zone crisis management since the debt turmoil began in late 2009, earning the nickname "Merkozy" for their sometimes disputed leadership.

Her relationship with Hollande, which one French pundit has already dubbed "Homer" perhaps due to its Greek challenge, may initially be cool as they are from opposing political families.

But the chancellor has promised to welcome the Socialist "with open arms" and the two calm, methodical leaders may be better suited temperamentally than the calculating Merkel and the impetuous, hyperactive Sarkozy.

Hollande has said he will press Berlin to lift its veto on issuing common euro zone bonds to harmonize borrowing costs within the currency area, or to allow the European Central Bank to lend directly to governments.

Both ideas are "red lines" for the centre-right German government, although Merkel has not ruled out euro zone bonds as a long-term prospect if Europe takes more steps towards a tighter political and fiscal union.

Surprisingly strong first quarter growth figures for Germany relieved pressure on shares and the single currency on Tuesday, but worries about the deepening impact of the euro area crisis and a possible Greek exit kept demand for safe-haven assets strong.

The German economy grew 0.5 percent in the first three months of the year, well ahead of forecasts due to a big rise in exports, but weakness elsewhere in the region meant the euro zone stagnated in the first quarter.

(Additional reporting by Catherine Bremer and Brian Love in Paris, Noah Barkin and Andreas Rinke in Berlin, Jan Strupczewski in Brussels and Richard Hubbard in London; Writing by Paul Taylor; Editing by Giles Elgood and Janet McBride)

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