By Lefteris Papadimas and Stephen Brown
ATHENS/BERLIN (Reuters) - 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 and avert bankruptcy.
In Berlin, the leaders of Germany and France, long at odds over how to involve private holders of Greek bonds in a new rescue package for Athens, said they had united behind a mild solution favored by Paris and the European Central Bank.
Signs that Europe's two central powers had put aside their differences, and were pressing for a quick solution to the crisis that has rocked the currency area since late 2009, boosted the euro and reduced risk premiums on Greek and other peripheral bonds after a week-long financial rout.
The elevation of Defense Minister Evangelos Venizelos to the finance ministry was aimed at securing party backing for an 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 percent and the Athens stock market index climbing 2 percent. [ID:nLDE75G0D4]
"AWAY FROM THE ABYSS"
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 percent of the country's annual economic output.
Reuters' calculations based on 5-year credit default swap prices from Markit show an 81 percent probability of Greece eventually defaulting on its debt based on a 40 percent recovery rate.
Jim O'Neill, the chairman of Goldman Sachs Asset Management, told Reuters Insider television said the risk of a Greek default was "getting closer" and slammed European policymakers for sparring in public with each other.
"It is like open theater," he said.
But Michael Leister, a rate strategist at WestLB, said the common front shown by Merkel and Sarkozy had moved the bloc "a couple steps away from the abyss," reducing fears of a disorderly default in the near-term.
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.
They have warned against a solution proposed by German Finance Minister Wolfgang Schaeuble, and initially backed by Merkel, that would have seen private holders of Greek debt swap their bonds for new ones with maturities that were seven years longer, giving Greece extra breathing room.
Merkel backed away from that idea on Friday, saying she now believed a softer solution based on the so-called "Vienna Initiative" -- a voluntary deal by banks in eastern Europe to maintain their exposures at the height of the financial crisis in 2009 -- was a "good foundation" for a Greek deal.
"There are concerns that we want to trigger a credit event. We don't want that," said Merkel.
"The quicker we get a solution the better," she said, brushing aside reports Berlin wanted to delay a final deal until September to work out the details of the private sector's role.
The announcement by Merkel and Sarkozy caused a sharp reduction of tensions in Europe's money markets, where banks had shown signs earlier this week of halting loans to each other because of their exposure to Greece.
The one-year euro/dollar currency basis swap spread, which expands when banks become unwilling to supply dollars to each other, narrowed to 25 basis points from 34 bps on Thursday, its widest in three months.
Both Merkel and Sarkozy said ECB backing was crucial for any deal. Any form of default could have led the central bank to refuse to accept Greek bonds as collateral, depriving Greek banks of vital liquidity on which they are 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.
"Germany is softening its stance, absolutely. This is a step forward, particularly the agreement to get the ECB on board with any solution," said Marco Valli, chief euro zone economist at Unicredit.
"But there are still big hurdles. Greece must get the austerity package through parliament. And Europe needs to come up with a way to do this rollover, which is easy to say but difficult to implement in practice."
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 has come against a backdrop of mass street protests, which turned violent on Wednesday. Efforts by Papandreou to form a national unity government collapsed the same day.
Olli Rehn, the European Commission's top official on economic matters, said he expected euro zone finance ministers to take decisions on a successor program for Greece on July 11.