Uncertainty over the impact of a potential Greek exit from the euro on the debt-laden 17-nation currency bloc drove a rush to safety by investors on Monday, sending the single currency to near four month lows and European shares down 1.5 percent.

Problematic negotiations on forming a new Greek government have increased the chances it will be unable to meet the conditions of its bailout deal, and a worsening fiscal position in Spain has added to the sense of crisis facing the region.

The list of political risks facing the euro area grew on Sunday when German Chancellor Angela Merkel's conservatives suffered a crushing defeat in an election in Germany's most populous state.

"Selling rallies in risk assets seems the best way to make money in most asset classes given the event risk is still very real this week." said Chris Weston, an institutional dealer at IG Markets.

Safe haven German bonds and the US dollar gained from the drive for safety with the June German Bund future  setting a record high of 143.28 in early trade. Riskier Spanish and Italian government bonds took the brunt of the selling with revived concerns about Spain's banking sector also sapping demand.

Spanish 10-year yields rose nine basis points to 6.12 percent with equivalent Italian yields 8 bps higher at 5.76 percent.

The negative tone in riskier assets will make for a difficult environment for Italy's 4.5 billion euros in debt sales later in the day, with borrowing costs set to rise. Spain also tests market appetite for its debt on Thursday.

The weakness across the peripheral debt market also adds pressure on the region's finance ministers to come up with a solution to Greece's difficulties in a meeting later in Brussels. They will also need to address growing calls for more pro-growth policies across the 17-member currency bloc.

Markets have begun to focus on an apparent split between the European Central Bank and political officials especially when it comes to how to handle the prospect of a euro exit by Greece.

"While most politicians argue for Greece staying within the euro, ECB officials seem to laying the case for Greece exiting EMU," Morgan Stanley said in a note to clients.

The split is adding pressure on the euro, which dipped to $1.2877, down 0.3 percent from late US trade on Friday, having lost 2.7 percent so far this month and 0.8 percent in April.

"The key driver in our opinion will be how the ECB reacts to the situation. We expect the ECB to ease policy, maybe through unconventional policies in coming months to support the situation in the periphery," said Raghav Subbarao, currency strategist at Barclays.           
The dollar meanwhile has risen 0.2 percent against a basket of major currencies to 80.45, helping send the Australian currency, often a barometer for global growth, down to $0.9979, its lowest level since December.

Underlining the negative sentiment caused by the crisis in Europe, China's decision on Saturday to cut the amount of cash banks must hold as reserves, normally been seen as a pro-growth move, only served to fuel fears that the global economic outlook was likely to get worse.     
China's move, triggered by last week's lacklustre industrial output data from what is the world's second largest economy, added to pressure on Asian share markets and commodities. 

The MSCI's broad world equity index was down 0.2 percent after it had fallen two percent last week, while MSCI main emerging market index fell over one percent.

In Europe, the key FTSE Eurofirst 300 index of top European shares was down over 1.5 percent at 1,0061.95, led by a fall of 2.4 percent in euro zone banks, and is only showing gains of 0.5 percent for the whole year. The combination of political uncertainty and a slowing Chinese economy drove Brent crude oil below $112 a barrel to $111.40. - Reuters