Greek Prime Minister George Papandreou sacrificed his finance minister on Friday and put his main socialist party rival into the job in a bid to force through an unpopular austerity plan to avert bankruptcy.
In Berlin, the leaders of Germany and France, Europe's two central powers, called for a quick deal on a second bailout for Greece with voluntary involvement of private bondholders, in accord with the European Central Bank.
Both voiced support for Papandreou and said the European Union must go on aiding Greece. But they gave no details of how private investors would contribute to the rescue -- an issue that has split the euro zone and rattled financial markets.
Nevertheless, their pledge of an early solution was enough to partially reverse a week-long financial market rout, with the risk premium on Greek and Spanish bonds narrowing and the euro regaining ground against the dollar.
The elevation of Defense Minister Evangelos Venizelos to the finance ministry was aimed at securing party backing for a crucial austerity package required for the EU and IMF to disburse emergency loans to keep Greece afloat next month and avoid a default which could unleash global financial turmoil.
Analysts said the socialist heavyweight was a second-best choice after Papandreou failed to persuade respected former ECB Vice-President Lucas Papademos to come aboard, but it enabled him to dump several ministers who had obstructed reforms.
Outgoing Finance Minister George Papaconstantinou, who negotiated a first 110 billion euro bailout for Athens last year and had the confidence of international lenders and markets, was moved to the environment ministry in a crisis-driven reshuffle.
"Venizelos is politically powerful and that might bode well for the implementation of fiscal consolidation, even though he has no track record in financial matters," UBS analyst Alexander Kyrtsis said.
Initial Greek market reaction was positive with bank shares rising by as much as 4% and the Athens stock market index up 2%.
But bond markets remain spooked by fears of a Greek default and most economists are overwhelmingly skeptical that Greece can ever repay its debt mountain, which has reached 340 billion euros or 150% of the country's annual economic output.
Reuters' calculations based on 5-year credit default swap prices from Markit show an 81% probability of Greece eventually defaulting on its debt based on a 40% recovery rate.
The ECB and the European Commission have warned that any form of private sector involvement that causes a "credit event" or a downgrading of Greek debt to default status could wreak devastating damage on the euro zone.
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 program for the sake of stability in Greece.
He removed the environment and labor ministers whom EU and IMF officials say have resisted attempts to speed up privatization and loosen labor 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% 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 program for Greece on July 11.
Both Sarkozy and Merkel dismissed reports that Berlin wanted to postpone agreement on a new 120 billion euro program, including 30 billion in privatization 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.