Euro zone debt fears send world stocks reeling

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  A trader reacts in front of the DAX board at the Frankfurt stock exchange September …

LONDON (Reuters) - World shares tumbled 2 percent on Monday with European equities down 3 percent for a more than 20 percent loss this year as investors worried Greece was edging closer to default.

Japan's Nikkei closed at a 2-1/2 year low and Wall Street looked set for sharp losses.

Yields on long-term core euro zone debt, home to safety plays during times of strife, fell sharply and the euro slumped against the dollar and yen.

The cost of insuring peripheral euro zone debt against default rose, to record levels for Greece and Portugal, while Italy saw its cost of borrowing over 12 months surge at a treasury bill sale.

Markets were partly reacting to the failure over the weekend of the Group of Seven industrialized nations' finance ministers to come up with more than a stated commitment to help turn the world economy around.

But they were mainly focused on the euro zone debt crisis.

"Europe is not just lurching from one crisis to another. It is lurching into a new one before the previous one is solved," said Makoto Noji, senior strategist at SMBC Nikko Securities.

The pan-European FTSEurofirst was down 3.1 percent.

German policymaker Juergen Stark's resignation from the European Central Bank's board on Friday underscored internal divisions over its bond-buying program -- one of the bank's main weapons to fight the debt crisis, by forcing down yields on debt of countries under pressure from the bond markets.

Fears about a Greek default rose last week after senior politicians in German Chancellor Angela Merkel's center-right coalition started talking openly about it.

International lenders threatened last week to withhold a sixth bailout payment of about 8 billion euros ($11 billion) because of repeated fiscal slippage and Athens said on Monday that it has cash for only a few more weeks.

The government announced on Sunday a new property tax to make sure it would meet its budget targets and qualify for the tranche.

"The Greek situation is dominant, chances of some sort of default have increased -- the Germans seem to be hinting at that," one bond trader in Europe said.

EURO SINKS

The euro dived to a seven-month low against the U.S. dollar and a 10-year trough versus the yen.

"The outlook for Greece is almost completely unknown. Support for the country appears to be shaking. The market is starting to think the worst could happen," said Katsunori Kitakura, chief dealer at Chuo Mitsui Trust and Banking.

"It's as if policymakers are starting to prepare for that," Kitakura said.

The euro fell as low as $1.34949, its lowest since February, before recovering to around $1.3634.

On bond markets, Italian and Spanish government bond yields rose, feeling the pressure of upcoming debt supply and the rising concern over Greece.