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The common currency fell as low as $1.3550 and to around 104.90 yen, as more negative news flow from Europe over the weekend hit already shaky sentiment.

There is little in the way of market-moving data on Monday and nothing concrete came from the Group of Seven finance chief meeting on Friday to distract investors from the euro zone's woes.

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

This came on top of Juergen Stark's surprise departure at the European Central Bank last week, which has highlighted major disagreement among top policymakers on how to tackle the region's debt problem.

Markets are also bracing for possible ratings downgrade on France's top banks, as well as Italy's sovereign rating. Moody's warned on June 17 that it may cut Italy's credit ratings in the next 90 days.

"By Friday at the latest, it is likely Italy will have their Aa2 rating from Moody's lowered ... Moody's rating of Italy is currently two notches below AAA, compared with three notches with Fitch and four notches with S&P, this can be seen as catch-up," Richard Kelly, head of European rates and fx research at TD Securities wrote in a note.

The euro was last at $1.3605 in very choppy trade, down from $1.3665 late in New York on Friday. It was seen heading toward support around $1.3410, the 50 percent retracement of June 2010 to May 2011 rally.

Against the yen, the common currency was at 105.21, having fallen as low as 104.90 on EBS, depths not seen since mid-2001.

With the Swiss franc no longer a safe harbour due to Swiss National Bank selling, and the yen also dogged by the danger of intervention from Japan's authorities, the greenback became the best performer among major currencies.

The dollar index hit 6- month highs at 77.580 and was last up 0.3 percent on the day at 77.399. Against the yen, the dollar was at 77.49, holding near a one-month high around 77.85 set on Friday.

"For now, your best bet is a higher U.S. dollar against most currencies, but in particular against the euro and the commodity currencies," said Joseph Capurso, strategist at Commonwealth Bank in Sydney.

Indeed, commodity currencies were under pressure on Monday with the Australian dollar falling to a near three-week low around $1.0397. It was last at $1.0404.

Trading was choppy with volumes likely to be thinner than usual as several centres in Asia, including China, are closed for a holiday.

(Editing by Wayne Cole)

Juergen Stark's premature departure from the European Central Bank because of his opposition to its controversial bond-buying program was described by German policymakers and editorial writers as a "wake-up call" for Germany.

It comes roughly seven months after Axel Weber, another monetary hawk in the post-war German tradition, abruptly resigned his post as head of the Bundesbank and withdrew his candidacy for the top post at the ECB.

That decision shocked the German policy establishment, but at the time many saw it as a one-off move by an impulsive man who had clashed loudly and publicly with President Jean-Claude Trichet over the extraordinary measures taken by the ECB to safeguard the single currency.

The resignation of Stark, a loyal, dedicated central banker who had kept his doubts about ECB policies to himself, tells a very different story, and has unleashed a wave of anxiety across Germany about the direction of 12-year-old single currency bloc.

Taken together, the departures are seen by many as indications of a southern European takeover of the ECB's policy-setting council, a worry sharpened by the looming presidency of Italian Mario Draghi, who takes Trichet's place in November.

Former Bundesbanker Edgar Meister called at the weekend for changes to the ECB's one-country, one-vote rule, saying it was "unbelievable" that a country such as Germany that was shouldering the biggest burden in the crisis could be overruled by central bankers from smaller countries that have already been rescued or are at risk of a bailout.

Norbert Barthle, a senior lawmaker from Merkel's Christian Democrats (CDU) who sits on parliament's budget committee, told Reuters that Stark's exit was "a rejection of the policies that the ECB has pursued and a clear signal that the situation in the broader euro zone has reached a really critical point."

"MORE EUROPE" STRATEGY

The implications for Merkel and Berlin's approach to the euro zone crisis are profound.

Criticized for focusing too much on domestic politics and failing to provide clear leadership in the bloc, Merkel shifted her approach this summer and began demanding "more Europe" as the solution to the bloc's deepening crisis.

She made clear last week in a speech to the Bundestag, the lower house of parliament, that changes to the EU's Lisbon Treaty to bring about closer fiscal integration between the euro zone's 17 member states should no longer be taboo.

After Stark's resignation, the domestic hurdles to that goal have risen substantially.

Julian Callow, an economist at Barclays Capital, said the political effect of Stark's resignation "could complicate Germany's involvement in additional bailout programs."

Merkel received a boost last week when the Constitutional Court rejected lawsuits seeking to retroactively block Berlin's participation in bailouts of Greece, Ireland and Portugal, albeit while giving parliament more say in future bailout moves.

But after Stark, her drive to secure a conservative majority in parliament for a bigger, bolder euro zone rescue facility on September 29 may have become more difficult again.

Merkel still seems likely to deliver that, but subsequent Bundestag votes on a second aid package for Greece and the launch of a permanent bailout fund -- the European Stability Mechanism (ESM) -- present a huge challenge to her leadership.

The Free Democrats (FDP), junior partners in her ruling coalition, are considering asking their 66,000 members whether to support the ESM. If a majority vote against, the leadership will be obliged to adopt that position as FDP policy.

Merkel's other coalition partner, the Bavarian Christian Social Union (CSU), is also agitating -- to boot Greece out of the euro zone.

A CSU policy paper obtained by Reuters over the weekend states that countries that do not respect rules on budgetary discipline should "expect to have to leave the currency union."

DEFAULT MORE LIKELY

A Greek exit from the euro zone still seems remote, and in any case, German officials say in private, such a decision would ultimately be for the government in Athens to take.

But a default no longer seems out of the question. The FDP economy minister, Philipp Roesler, said in an article published on Sunday that an orderly bankruptcy of Greece was no longer a taboo and demanded automatic sanctions for heavily indebted countries that did not meet their obligations.

Despite Greek Prime Minister George Papandreou's pledge on Saturday to do all in his power to avert bankruptcy, it is no longer a given that inspectors from the EU, IMF and ECB will sign off on the next aid payment after leaving Greece in a huff over missed deficit targets this month.

A German Finance Ministry source told Reuters at the weekend that Berlin's working hypothesis now was that Greece would ultimately default on its 340 billion euro debt mountain.

In a possible sign that markets are being prepared for this, French central banker Christian Noyer, speaking on Friday after a G7 finance ministers' meeting in Marseille, said Greek debt did not represent a threat to any bank outside of Greece.

Barthle, the budget expert in Merkel's party, told Reuters: "The problems in Greece are not getting smaller, they are getting bigger, and will create significant problems for the bloc ...

"I am eager to see what the troika report says. The way things are looking, you can't rule out a restructuring of Greece's debt any more."

Would a default force Greece out of the euro zone? A senior European banker told Reuters that one would have to follow the other, even if there is no legal mechanism for a country to leave the bloc.

But senior sources in Berlin and Brussels said all would be done to avoid such a humiliating setback for the currency union.

The focus instead appears to be on ensuring national parliaments approve new powers for the bloc's rescue mechanism -- the European Financial Stability Facility (EFSF) -- as soon as possible.

Only after that would the EFSF be really in a position to minimize the damage from a Greek default by providing credits to stricken member states and banks across Europe.

Given the time needed to win EFSF approval in all 17 euro states, the chances seem good that EU, IMF and ECB inspectors will nod through the latest Greek aid tranche within weeks.

But Merkel's real test will come in an eventual parliamentary vote on the permanent ESM.

The vote is already shaping up as a referendum on her leadership; if she fails to secure a majority from within the ruling coalition, the pressure to call an election from the opposition and parts of her own party will be huge.

"The resignation of Juergen Stark is a devastating signal for Angela Merkel," the conservative daily Die Welt said on Sunday. "Life is only going to get more difficult for her."

(Reporting by Noah Barkin; Editing by Kevin Liffey)

The ECB is the one institution that has kept the euro zone afloat in the sovereign debt crisis and prevented a bond market meltdown. The European Union has no federal government or common fiscal authority and speaks with many dissonant voices.

Juergen Stark's departure from the ECB's Executive Board in despair at the policy of buying government bonds to prevent the crisis spreading comes as policymakers in Berlin and beyond are preparing for the growing possibility of a Greek default.

It seems bound to complicate the next round of crisis management because it has injected the poison of inter-state politics as well as ideological division into the independent central bank.

"It's the ECB that is holding the show together, so anything that weakens the ECB is bad news," said an EU official involved in financial crisis management.

Stark's walkout will further sap the ECB's credibility with Germany's conservative financial establishment, which saw the bond-buying as an improper means of financing government debt, and among voters in Europe's largest economy.

That could make greater fiscal integration in the euro zone politically harder to achieve at a time when Chancellor Angela Merkel is coming to realize that a big leap forward in economic governance is needed to preserve the single currency.

It risks importing a north-south divide, between self-styled virtuous creditor countries and peripheral states seen as profligate and feckless, into the central bank.

At worst, Stark's departure may constrain the ECB's ability to act decisively in the coming months when the debt crisis enters an even more dangerous phase.

HAMSTRUNG

"This comes at a very, very bad time and it's certainly serious," said Jean Pisani-Ferry, director of the Bruegel economic think-tank in Brussels.

"If the ECB is shackled in its ability to buy Italian and Spanish bonds and at the same time we have to do a real restructuring of Greece's debts, with a proper haircut, we risk a contagion shock spreading to other countries. If the ECB is hamstrung by a lack of consensus, that is the risk."

A growing number of policymakers, as well as market economists, are convinced it is only a matter of time before Greece, which keeps falling behind on its fiscal targets, will have to default.

A source at this weekend's G7 finance chiefs' meeting in Marseille said the troika of EU, ECB and IMF inspectors, who suspended talks with Athens last week, would probably find a formula in its progress report to allow the next 8 billion euro ($11 million) tranche of bailout funds to be paid in October.

That would keep Greece going for a couple more months until European parliaments approve new powers for the EFSF rescue fund to give preventive credit lines to euro zone member states, buy bonds in the secondary market and lend money to recapitalize banks.

The source said the German Finance Ministry was increasingly convinced that Greece will not be able to avoid default for much longer, so ring-fencing the euro zone's weakest debtor and limiting contagion will be crucial.

Even when the EFSF has its new powers, it will require the unanimous agreement of the 17 euro zone member states to use them, with the German parliament having just gained a bigger oversight role on those decisions. Political hurdles abound.

Markets may bid up euro zone bond yields again in anticipation of the ECB pulling out of bond-buying and handing over to the inexperienced EFSF, traders say.

The ECB has bought a total of 135 billion euros' worth of Italian, Spanish, Greece, Irish and Portuguese bonds so far.

The rescue fund may find itself short of firepower in a crisis. It will have about 380 billion euros in uncommitted funds. Italy alone has 1.9 billion euros of outstanding government bonds, of which 45 percent are held by foreigners.

HARDER LINE

The replacement of Stark on the ECB board by the more pragmatic German junior finance minister Joerg Asmussen, the seasoned crisis manager proposed by Berlin on Saturday, may reduce ideological tensions at the central bank.

But it could also force incoming ECB President Mario Draghi, who succeeds Jean-Claude Trichet on November 1, to take a harder line on ending bond purchases and sticking to the bank's core mandate of fighting inflation.

Draghi has already warned governments, including his native Italy, that continued bond-buying cannot be taken for granted.

"The next step will be increased pressure on the ECB to keep its hands clean. Stark is from the German school that sees this kind of intervention as bad in principle," said Josef Janning, director of research at the European Policy Center in Brussels.

"His likely successor will be less orthodox and more of a political crisis manager. But Stark may use his new freedom to speak out. That could make things more complicated for Merkel and for Draghi," the German political scientist said.

Stark's resignation could also affect international confidence in the ECB and the euro zone at a crucial moment.

"Politics has never been completely absent from the ECB but this has now been reinforced. This awakens the idea that the ECB is still a structure that amalgamates national institutions and views, not primarily individuals belonging to its board," Pisani-Ferry said.

"You have to think about how this looks from New York. It looks as if these people can't even sit around the same table and work things out."

($1 = 0.729 Euros)

(Additional reporting by Annika Breidthardt in Marseille and Luke Baker in Brussels; Editing by Kevin Liffey)