BRUSSELS/ATHENS (Reuters) - Euro zone finance ministers dismissed talk of Greece leaving the euro zone as "propaganda and nonsense" on Monday, but said the country had to respect the terms of the bailout program agreed with the EU and the International Monetary Fund.
If Greece can form a government and that government signs up to the bailout agreement, then it is possible some of the targets in the program could be softened, the chairman of the euro zone finance ministers, Jean-Claude Juncker, said.
"I don't envisage, not even for one second, Greece leaving the euro area. This is nonsense; this is propaganda," Juncker, who also serves as Luxembourg's prime minister, told reporters, dismissing those who threaten Greece with expulsion.
"The exit of Greece out of the euro was not the subject of our debate today. Absolutely no one, absolutely no one, argued in that sense," he said after six hours of talks among the 17 ministers from the euro zone countries.
"But the Greek public, the Greek citizens, have to know that we agreed on a program and this program has to be implemented."
Eight days after inconclusive elections, Greece's political parties have failed to form a coalition and opinion polls show that anti-bailout parties would perform most strongly in a fresh vote, which is likely next month.
Last ditch talks led by President Karolos Papoulias on Monday looked unlikely to make headway after the leader of the radical leftist SYRIZA party said he would not attend and another left-wing leader refused to take part in any coalition without him.
The central demand of SYRIZA leader Alexis Tsipras is to tear up the EU-IMF bailout agreement, which imposes harsh austerity on Greece.
EU officials have stressed that room for renegotiation of the 130 billion euro bailout is very small, although Juncker appeared to offer some leeway to Athens, if Greek parties manage to overcome differences and back the bailout reform plan.
"If there were to be dramatic changes in the circumstances, we wouldn't preclude a debate about an extension of the period (for Greece to meet targets)," Juncker said.
"I didn't say there was any intention to extend the periods, we have to do things in the appropriate order," he said.
"We need a Greek government. The Greek government would have to make clear it was fully committed to the program, and then if there were exceptional circumstances, we wouldn't exclude the possibility of discussing this issue.
"It wasn't discussed today because those two other conditions were not met: we haven't got a Greek government and we haven't got any particular circumstances to warrant this discussion. Anyway, there wouldn't be any substantive change involved."
With Greece set to run out of money as early as next month and no new government in place to negotiate the next aid installment, investors have begun betting that a chaotic Greek default and euro exit will happen sooner rather than later.
Talk of any member exiting the euro zone used to be a taboo for policymakers. Not any more.
Over the weekend, European Central Bank policymakers Luc Coene and Patrick Honohan both openly voiced the possibility of Greece leaving the currency bloc and concluded that it would not be fatal for the euro zone.
But there are powerful incentives for keeping Greece afloat, not least that the ECB and euro zone governments are major holders of Greek government debt.
A hard default could leave them with heavy losses and if the ECB needed recapitalizing as a result, that bill would also fall on its members' governments, with Germany first in line.
The biggest fear for the euro zone is that chaos in Greece could drag the much larger economies of Spain and Italy down and threaten the entire currency area's existence, a risk markets are beginning to price in.
The cost of insuring Spanish government debt against default hit an all-time high on Monday and the premium investors demand to hold Spain's debt rather than Germany's reached its highest point in the currency bloc's history.
Euro zone finance ministers welcomed Spain's efforts to recapitalize its banking sector -- hit hard by a collapse of the Spanish real estate market -- and its idea of external verification of the sector's health.
But Madrid must move fast, euro zone ministers said.
"We call on the Spanish authorities to speed up the external assessment of the situation in the banking sector and to take the necessary steps to put in place credible backstop mechanisms that can be used in case of need. Indeed, in the current circumstances, speed is of the essence," Juncker said.
Italy's borrowing costs rose at an auction but it paid less to borrow over three years than trading prices had suggested beforehand and it sold the maximum planned amount of 5.25 billion euros.
Moody's Investors Service downgraded the long-term debt and deposit ratings for 26 Italian banks on Monday, citing the country's recession and rising bad debt levels.
Spain, beset by concerns about its banking system despite moves last week to shore it up, raised 2.9 billion euros in 12- and 18-month Treasury bills, with yields on the shorter paper up by around a seventh from the last such sale in April.
As always, decision-making will rest first and foremost with Germany and Chancellor Angela Merkel, who has insisted that tough debt-cutting programs are the primary route back to health for the euro zone.
Merkel's conservatives suffered a crushing defeat on Sunday in an election in Germany's most populous state, a result which could embolden the left opposition to step up attacks on her European austerity policies.
New French President Francois Hollande will visit Merkel in Berlin on Tuesday after he is inaugurated to press for a European growth strategy. Germany has not opposed the idea but insists it cannot be funded by extra government spending that would drive debt back up.
"There is no contradiction between fiscal consolidation and growth-oriented policies. To the contrary, they are mutually reinforcing and should be pursued entirely," Juncker said.
"We agreed that consolidation efforts should be growth-friendly with a focus on forward-looking expenditure like investment and innovation and pro-growth projects, and should be anchored into a credible multi-annual framework. We'll come back to this at our next meeting on June 21," he said.
Investors are already looking to the ECB to return to the fray. It created more than 1 trillion euros of three-year money in December and February, and signaled afterwards that it had done all it could.
Reporting by Renee Maltezou and George Georgiopoulos in Athens, Valentina Za in Milan, Paul Day in Madrid, Emelia Sithole-Matarise in London; Writing by Mike Peacock; Editing by Luke Baker and Lisa Shumaker