Talks to restructure Greece's debt hit a new impasse after eurozone finance ministers rejected an offer from private bondholders because the cost of sweeteners on new Greek bonds were too high.
The blow came after a day in which European markets had risen on hopes that attempts to resolve the latest phase of the Greek debt crisis would be successful.
Eurozone ministers have demanded that negotiations between the Greek government and Institute of International Finance (IIF) reach agreement on a lower average coupon, or interest rate, on new Greek bonds issued in return for a haircut on existing debt held by private investors.
"The ministers have sent the offer back for negotiations," said an official last night. "The ministers want a lower coupon than presented in the offer."
The offer, negotiated during tense talks that rattled markets last week, assumed an average coupon on new Greek bonds of 4pc.
The new bonds, likely to have maturity of 30 years, would replace existing Greek debt as sweetener for writing down existing Greek bonds owned by banks and private investors.
The International Monetary Fund (IMF (Berlin: MXG1.BE - news) ) has insisted that the coupon rate must not exceed 3.5pc on average if the deal is to reduce the currently unsustainable burden of Greek debt to manageable levels.
If the coupon is 4pc then the cost for Germany and other eurozone countries of a second Greek bailout in March will rise beyond a €30bn figure earmarked for sweetening a debt write down for the private sector.
Jean-Claude Juncker, head of the eurozone finance ministers' group, last night confirmed that the group wants a rate below 4pc and insisted that rates must be on average 3.5pc or below until 2020.
Eurozone officials have insisted that there are no plans to increase the €130bn of official financing for Greece under a second bailout package agreed in October.
A deal with its private creditors is a precondition for Greece to get the second bail-out from its eurozone partners, after it received €110bn in May 2010.
Angela Merkel, the German Chancellor, said there would be no question of a temporary loan for Greece if the private-sector involvement (PSI (Euronext: ^PSI20 - news) ) dragged on. Wolfgang Schaeuble, the German finance minister, said he wanted a second bail-out programme for Greece to be in place by March.
Athens faces a March 20 deadline to repay €14.4bn in debt.
As well as the terms of the Greek debt restructuring, eurozone finance ministers were meeting in Brussels last night to discuss new treaties designed to impose greater fiscal discipline ahead of the EU leaders summit on January 30.
Mario Monti, the Italian Prime Minister, said no decision had been reached on the treaty concerning the permanent bail-out fund, the European Stability Mechanism (ESM).
Earlier on Monday, investors had shrugged off the stalemate in the negotiations between Greece and its private sector bondholders, optimistic that eurozone policy-makers were determined to secure a deal and avoid a messy default.
The FTSE 100 closed up 0.9pc at 5,782.56, the highest close price since July 29. The DAX in Frankfurt and CAC 40 (Paris: ^FCHI - news) in Paris both rose 0.5pc, to 6,436.62 and 3,338.42 respectively.
Benchmark 10-year Italian bond yields fell by 14 basis points to 6.073pc, reflecting the calmer mood among investors.
Christine Lagarde, head of the IMF, joined calls from the Italian Government and Spain for Europe (Chicago Options: ^REURUSD - news) to boost the size of is future bail-out fund, the European Stability Mechanism (ESM).
"We need a larger firewall," she said. "Without it, countries like Italy and Spain, that are fundamentally able to repay their debts, could potentially be forced into a solvency crisis by abnormal financing costs."
Germany may be open to boosting the aid limit from €500bn, Government officials in Berlin said. However a spokesman for Chancellor Merkel last night denied reports the country was ready to agree to an increase of the size of the bailout fund to €750bn.
Ms Lagarde set out a raft of other proposals to fight the eurozone crisis, including lower rates imposed by the European Central Banks and the creation of eurobonds, as she warned of dimmer world growth prospects.
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