European stocks closed higher Tuesday as German Chancellor Angela Merkel sought to reassure investors over fears that Greece is heading for a chaotic default as Europe struggles to contain a crippling financial crisis.

In London, the FTSE 100 index of leading British shares was up 0.9 per cent, while Germany's DAX added 1.9 per cent. France's CAC-40 was up 1.4 per cent.

European investors were cheered by the dismissal by French banks of market rumours that they were facing shortages of cash to finance their operations, and by the confirmation by Italy's finance minister that officials had met with China's sovereign wealth fund about buying Italian bonds.

Despite that, borrowing costs for the Italian government rose as it auctioned off €3.9 billion ($ 5.3 billion Cdn.) It had to pay an interest rate of 5.6 per cent.

That was the highest rate it has had to pay since the euro was established in 1999 and marked a fairly hefty rise from the previous auction's equivalent of 4.9 per cent.

The euro earlier traded lower against the U.S. dollar after a spokesman for French President Nicolas Sarkozy denied market rumours that he and Merkel would make a statement after their teleconference on Wednesday with Greek Prime Minister George Papandreou on how to deal with the crisis.

But by late afternoon, the shared currency was trading up 0.3 per cent at just under $1.37 US.

Greek bond yields soar

Traders are worried about the exposure French, German and American banks have to Greek debt.

Fears of an imminent Greek default pushed interest rates on the country's 10-year government bonds up Tuesday to a new record of over 24 per cent.

Merkel rejected the notion raised on Monday by her deputy that a Greek bankruptcy would provide a quick solution to the  crisis. That suggestion spooked European markets yesterday.

She argued instead that Europe must keep on with efforts to cut budget deficits and improve its competitiveness, and that resolving the crisis would be "a very long, step-by-step process."

"Everything that I hear from Greece is that the Greek government has hopefully understood the signs of the time and is now doing the things that are on the daily agenda," Merkel told rbb-Inforadio.

She suggested that even an orderly default couldn't come any time soon.

Merkel 'optimistic' about second Greek bailout

"We must always keep in view that we do everything we do in a controlled way, that we know the consequences, because otherwise a situation could very quickly arise in the eurozone ... that none of us wants and that could have very, very difficult consequences for us all," Merkel said.

Greece is relying on rescue loans to remain solvent. But lagging efforts to tame a bloated budget deficit and enforce reforms are threatening that lifeline, which is conditional on fiscal progress.

Over the past few days, Greek Finance Minister Evangelos Venizelos has issued a series of pledges to accelerate delayed reforms meant to cut the cost and size of the public sector, and raised the prospect of firing up to 20,000 public servants — which would break a major taboo in a country where state employees have guaranteed jobs for life.

In a last desperate bid to plug the revenue hole, the government on Sunday imposed a new, two-year blanket tax on property.

The planned second Greek bailout by the European Commission, the European Central Bank and the International Monetary Fund has faced delays in implementation — not least because of Finland's demand for collateral for its contribution, which annoyed other Europeans.

Merkel said she was "very optimistic" of resolving that.

"I think we want to, and will, find a way that is in principle open to all partners and still fulfills Finland's requirements," she said.

With files from The Associated Press