By James Mackenzie and Andreas Rinke
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Just 24 hours before European leaders are due to adopt a plan to reduce Greece's debt burden, fortify European banks to withstand bond losses, and scale up the euro zone rescue fund to prevent market contagion, disputes raged in Rome and Berlin.
There was no also sign of a deal in negotiations to reduce Greece's debt to private sector bondholders, and uncertainties remained over the size of a planned bank recapitalization and the scope of leveraging of the rescue fund.
Chancellor Angela Merkel, fighting to secure parliamentary backing for euro zone rescue measures, said Germany opposed a phrase in the draft summit conclusions urging the ECB to go on buying troubled states' bonds.
The draft seen by Reuters supported a continuation of "non-standard measures in the current exceptional financial market environment."
"This sentence is not agreed with us," Merkel told reporters, adding that Germany did not want a declaration from politicians telling the ECB what to do.
An opposition lawmaker said parliament would try to point the ECB in the opposite direction on Wednesday, expressing the expectation in a joint motion that the ECB would stop its bond purchases on the secondary market.
The euro slipped and safe-haven German bond futures rose after Merkel's comments since continued ECB support is widely seen as crucial to stabilizing the markets.
In Rome, Prime Minister Silvio Berlusconi's faction-ridden cabinet failed to agree at an emergency session late Monday on raising the retirement age, a key economic reform demanded by Italy's EU partners as a condition for supporting its bonds.
Berlusconi responded truculently to public pressure from French President Nicolas Sarkozy and Merkel at an EU meeting on Sunday, saying that no one could teach Italy lessons.
The European Commission said the aim was not to humiliate Italy, but to ensure that a member state meets its commitments on budget discipline and economic coordination.
"It's not about challenging sovereignty, it's not about lecturing, it's not about humiliating," said the Commission spokesman on economic issues, Amadeu Altafaj.
"We have 27 democratically elected governments, which have agreed on reinforcing surveillance and on having a higher degree of coordination of their economic policies. It makes sense. It's one of the main lessons of the crisis."
With Berlusconi's Northern League coalition partners opposed to raising the retirement age to 67 from 65, there was growing talk that a government crisis could lead to an early parliamentary election. Northern League leader Umberto Bossi told reporters the center-right cabinet was at risk over the EU reform demands.
As the coalition parties held separate meetings, President Giorgio Napolitano said in a statement Italy must do everything to reduce the risk to government bonds by making its commitment to cut public debt more credible and boosting growth.
GAME OF CHICKEN
The euro zone's number three economy is at the center of the storm, despite European Central Bank intervention to buy its bonds, because it needs to issue some 600 billion euros in bonds in the next three years to refinance maturing debt.
Italy has the euro zone's largest sovereign bond market, with public debt of 1.8 trillion euros, 120 percent of GDP.
Italy was not the only unresolved item on the summit agenda and Bank of England governor Mervyn King voiced skepticism from outside the euro zone as to whether the currency area's leaders would be able to find solutions.
"Even on July 21 there was a package which they held out as being the solution to it. The underlying problems hadn't changed at all and they won't change," King told the House of Commons treasury committee.
"The aim of the measures to be introduced over the next few days is to create a year or possibly two years' breathing space. The underlying problems still have to be resolved."
Tough negotiations were continuing between euro zone governments and Greece's private bondholders over the scale of a write-down they will have to accept on Greek debt holdings.
Governments are demanding that banks and insurers accept a 60 percent "haircut" as part of a second rescue package to make Athens' debt mountain, set to reach 160 percent of economic output this year, more sustainable.
Bank negotiators have offered a 40 percent write-down and warned that forcing them into deeper losses would amount to a forced default with what banks say will be devastating consequences for the European financial system.
EU diplomats said the outcome of the game of chicken between governments and banks was uncertain, but some forecast a last-minute deal on a 50 percent write-down.
Greek Prime Minister George Papandreou said: "I hope that tomorrow we will come to decisions, this is our partners' will.
"Tomorrow we want to put an end, turn a page, in order for the country to move forward."
Many uncertainties remain also over complex options to increase the firepower of the 440-billion-euro ($600 billion) European Financial Stability Facility so it can prevent contagion spreading from Greece to Italy and Spain.
A working paper circulated to German lawmakers on Monday set out two options that might be used separately or in tandem to provide partial insurance on new Italian and Spanish bonds and to attract foreign sovereign and private investors via a special purpose investment vehicle (SPIV).
EU officials said much of the detail of the leveraging may be left until after Wednesday night's summit, due to start with a short meeting of the full 27-nation European Union at 1600 GMT, followed by a longer session of the 17 euro zone members.
Even if the leaders agree on the leverage plan for the EFSF, the arrangements could take several weeks to put in place and most euro zone leaders are counting heavily on the ECB to go on buying Italian and Spanish bonds.
Outgoing ECB President Jean-Claude Trichet, who retires next week, had signaled that the central bank was looking to exit from the deeply controversial bond-buying policy once the EFSF gained its new powers to intervene on bond markets.
EU officials say they are counting on his successor, Mario Draghi of Italy, to continue the purchases as long as is necessary to stabilize the bond markets.