German Chancellor Angela Merkel backed aid for Greece with IMF involvement as a last resort on Thursday, and the European Central Bank extended looser funding rules in a big reprieve for Athens.

Ahead of a high-stakes European Union summit that begins later on Thursday, Merkel signaled in a speech to parliament that she was ready to do a deal on supporting Greece, whose debt crisis has shaken the credibility of the currency bloc.

But she made clear any agreement had to be on strict German terms. Some members of the euro zone and the ECB are dead-set against International Monetary Fund (IMF) involvement, fearing such a move would show the bloc is incapable of solving the deepest crisis in its 11-year existence on its own.

At the summit today and tomorrow, the German government will push its view that any emergency support should come from a combination of the IMF and joint bilateral help from the euro zone. But again I say, this can only be a last resort, Merkel said.

A good European is not necessarily one who offers help quickly. A good European is one that respects the European treaties and national rights so that the stability of the euro zone is not damaged, she said.

Before she spoke, ECB President Jean-Claude Trichet offered some good news to Athens, announcing the central bank would extend looser collateral rules, which were due to expire at the end of this year, into 2011.

Greece was at risk of having its bonds rejected as collateral with the expiry of the relaxed rules, a potentially new liquidity crunch for Athens to face.

It is the ECB's contribution to the resolution of the Greek crisis, said Nomura economist Laurent Bilke. It is also a message to the EU that Greece deserves support.

EURO EDGES UP, SPREADS NARROW

The euro, which hit a 10-month low of $1.3285 earlier on Thursday, edged up to $1.3345 after Trichet's announcement, while the spreads between Greek bond yields and German benchmarks narrowed slightly to below 320 basis points.

Athens revealed a huge budget deficit last October, shocking investors who sent Greek borrowing costs soaring while it tried to get the deficit down with unpopular austerity measures.

It needs to borrow some 16 billion euros between April 20 and May 23 alone to refinance maturing debt at twice the rate Germany has to pay to borrow.

Greece says it needs only a standby aid package to reassure nervous financial markets and that it can get by without having to resort to using the money that is set aside for it.

But Germany, Europe's biggest economy, faces public opposition to any bailout for Greece before a regional election in May and fears any financial assistance would face a legal challenge at home.

As a condition for any support package, Merkel made clear in parliament that EU rules must be rewritten to provide harsher punishment for deficit sinners.

The German people gave up the deutschmark based on their faith in a stable euro. This faith, and this is the view of the entire German government, cannot be disappointed under any circumstances, she said.

She vowed to push for enhanced surveillance powers for EU statistics agency Eurostat and tougher penalties for budget-busters than those currently contained in the EU's Stability and Growth Pact.

CONTAGION FEAR

EU leaders are concerned Greek's debt-servicing problems could spread to other countries in the euro zone including Portugal, Spain or Italy.

Fitch downgraded Portugal's sovereign debt rating by one notch to AA- on Wednesday, reflecting a deterioration of the rating agency's confidence in Portugal's economy.

The Portuguese parliament was due to vote later on a resolution of support for the government's austerity program.

The EU should show solidarity with Greece and work out a common position which would end all market speculation. A quick decision by the EU would offer the best help, said Polish Prime Minister Donald Tusk, whose country does not use the euro.

The Greek debt crisis is not formally on the summit agenda, despite pressure to discuss it from the executive European Commission along with the main theme of creating jobs and boosting economic growth.

Efforts by some countries to arrange a separate meeting of euro zone leaders to discuss Greece had not borne fruit as of Thursday morning, but diplomats were not ruling out such a meeting on Thursday night.

EU leaders have been split over the form of any Greek rescue package and whether the IMF should be involved.

Luxembourg Foreign Minister Jean Asselborn told Deutschlandfunk German radio on Thursday that calling on the IMF for financial aid would damage the euro.

France has also resisted any role for the Washington-based lender, saying it would be a political humiliation and signal that the euro zone was incapable of solving its own problems.

But diplomats said Paris now seemed willing reluctantly to concede a role for the IMF as the price for securing German backing for a rescue mechanism.

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