The European Central Bank has stopped offering liquidity to some Greek banks it does not consider solvent, and international concern about the euro zone rose as Athens called new elections that look set to be won by parties opposing austerity measures.
Fears that Athens is on the brink of crashing out of the euro zone and igniting a renewed financial crisis have rattled global markets and alarmed world leaders, with Greece set to figure high on the agenda at a G8 summit later this week.
The risk of the contagion spreading to bigger European economies that are vulnerable due to high debt or weak banks has sent stocks and commodities tumbling, and driven Europe's single currency towards its lowest levels this year.
"The core question will be not Greece, but Spain and Italy," World Bank President Robert Zoellick said on Wednesday. If Greece left the euro zone, the ripple effects could be very damaging and reminiscent of when Lehman Brothers investment bank collapsed in 2008, spreading panic on global financial markets.
Recession-hit Spain, which faces deep concerns over the health of its banks, is set to see its medium-term borrowing costs rise sharply at an auction on Thursday of 1.5-2.5 billion euros of bonds expiring in 2015 and 2016.
FRAGILE BANKING SYSTEM
Highlighting the fragile state of Greece's banking system, the ECB said on Wednesday it had stopped providing liquidity to some lenders because their capital was too depleted, confirming an earlier report by Reuters.
"As recapitalisation wasn't in place, the ECB stopped monetary policy operations," a euro zone central bank source told Reuters, declining to be identified.
That meant the affected banks can no longer offer assets to the ECB as collateral for loans, and would have to seek costlier emergency financing from the Bank of Greece.
It was not immediately clear which banks, or how many of them, were affected. One person familiar with the matter said the capital of four Greek banks was so low they were operating with negative equity.
International Monetary Fund chief Christine Lagarde warned of "extremely expensive" consequences were Greece to leave the euro zone, a once taboo possibility that European leaders have now begun to discuss openly.
Echoing Zoellick's comments, Lagarde told Dutch television any Greek departure from the euro "would be extremely expensive and hard, and not just for Greece".
LEFTIST LEAD IN POLLS
In March, Greece agreed to extensive budget cuts as conditions of a 130 billion euro bailout package organised by the European Union and International Monetary Fund.
But the country has had no elected government since an inconclusive election on May 6 at which parties opposed to the unpopular austerity measures that were part of the bailout did well, raising the chance that the rescue funds could be halted and push the country towards bankruptcy and out of the euro.
The failure of pro- and anti-bailout parties to agree on a coalition forced President Karolos Papoulias to call the second election in two months, and prompted him to say the chaos risked causing panic and a run on bank deposits.
A new opinion poll confirmed that leftists who reject the bailout are poised to win next month, and the two establishment parties that agreed to the rescue are sinking further.
A little-known judge was installed as head of an emergency government on Wednesday and a senior finance ministry official appointed as finance minister in the early hours of Thursday, but the administration will have no power to take political decisions, only steer the country to the election on June 17.
"The only thing we are doing is waiting," said a government official who declined to be named.
An EU official conceded other Group of Eight countries, whose leaders meet at U.S. President Barack Obama's Camp David retreat at the weekend, had signalled heightened concern at the deepening political crisis in Athens.
"We have been confronted ... by a number of concerns on what might happen," the official said. "This concern has become more pronounced after the result of the Greek elections."
The leftists argue they can tear up the bailout deal and keep the euro, but European leaders say that if Greece fails to meet promises to them, lenders will pull the plug on financing.
Greeks have withdrawn hundreds of millions of euros from banks in recent days as the fears grow that the country might be forced out of the euro zone, although there has been no sign of a run on Athens bank branches.
ECB President Mario Draghi said that under the EU treaty, it wasn't his job to decide what happened to Greece.
"I want to state that our strong preference is that Greece will continue to stay in the euro zone," he said in Frankfurt. However, he added: "Since the treaty does not foresee anything on (an) exit, this is not a matter for the ECB to decide."