By Annika Breidthardt and Gernot Heller
Two euro zone officials said on Thursday France and Germany were considering holding another euro zone summit next week to try to bridge their differences, having already accepted that they will not be able to strike a deal on Sunday October 23.
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The major sticking point is over how to scale up the European Financial Stability Facility, a 440 billion euro ($600 billion) fund so far used to bail out Portugal and Ireland. France and Germany disagree over the best method to bolster the facility, with France fearing it could lose its triple-A credit rating if the wrong method is chosen and Paris is left exposed.
"Sunday's summit is unlikely to produce any real decisions, the real stuff will have to be done on Wednesday or even Friday," said one senior euro zone source. "It will be another euro zone leaders' summit."
EU officials responsible for convening summits could not confirm that a new date had been set.
Failure to agree on leveraging the EFSF will further damage confidence in the euro zone's ability to tackle its debt crisis after nearly two years of trying to get on top of a problem that started in Greece and now threatens Italy, Spain and even France, not to mention the broader global economy.
Despite the divisions on the EFSF, EU leaders have made progress on another critical element in tackling the crisis -- the recapitalization of European banks.
EU officials said all 27 member states had agreed that just short of 100 billion euros was required to bolster bank balance sheets, a substantial step forward in attempts to protect the system against the threat of a default in Greece or elsewhere.
Banks will be required to come up with the capital from shareholders first, and if that fails than national governments will provide the support. Only as a last resort will the EFSF be used to recapitalize institutions.
The International Monetary Fund and the EU also do not see eye-to-eye over the sustainability of Greek debts, with the IMF concerned that EU projections may be too optimistic and that deeper debt reduction is needed, EU sources told Reuters.
Without that payment Greece faces default, possibly dragging the larger economies of Spain and Italy into the mire and sending shockwaves through the European banking system.
HOW TO SCALE UP
The biggest challenge is agreeing on the method of scaling up the EFSF. France has argued the most effective way of leveraging it is to turn it into a bank which could use funding from the European Central Bank, but both the ECB and Berlin oppose this and the proposal appears to be dead.
Instead, there is an initiative to use the EFSF to guarantee a portion of potential losses on new euro zone debt, a way of trying to restore market confidence and convince investors that Italian and Spanish bonds are safe to buy.
By guaranteeing only a portion, perhaps a third or a fifth, of each debt issue, the EFSF's funds would stretch 3-5 times further, increasing it to around 1-1.5 trillion euros.
But analysts are concerned that such a plan could create a two-tier bond market, with bonds that have guarantees trading at a premium to the secondary market -- an outcome that would likely fuel the turmoil markets are already in.
Markets caught up with the downbeat tone. European shares fell and the euro weakened.
"I don't think they can meet expectations. The summit will fall well, well short of the kind of big bang needed to reassure the markets," said Simon Tilford, chief economist at the Center for European Reform in London.
Guidelines for changes to the bailout fund obtained by Reuters confirmed it will be able to buy bonds on the secondary market once a request from a country is approved by ECB and euro zone finance officials.
A draft statement for Sunday's summit showed euro zone countries will make rules to limit budget deficits and public debt part of national legislation by the end of next year.
Adding to uncertainty, EU officials said there was growing acceptance among key euro zone member states that further private sector involvement in Greek debt reduction may have to be forced, not voluntary -- an outcome ruled out up to now.
In July, private investors agreed to contribute 50 billion euros to reducing Greece's debt via a debt buyback and swap agreement, which equated to a 21 percent writedown. That is now seen as insufficient to make Athens' debts sustainable.
Greece remains mired in recession and its overall debt is forecast to climb to 357 billion euros this year, or 162 percent of annual economic output -- which few economists believe can be paid back.
While Europe's leaders rush to stop a larger writedown of Greek debt infecting others in the euro zone, ordinary Greeks are raging at the prospect of years more pain as the price of help from international lenders.
Clashes between rival groups of protesters broke out in front of the Greek parliament, interrupting a rally by tens of thousands against a tough new package of austerity measures due to be approved later in the evening. ($1 = 0.730 Euros)
(Additional reporting by Andreas Rinke and Madeline Chambers in Berlin, John O'Donnell, Julien Toyer, Jan Strupczewski and Luke Baker in Brussels and Michael Shields in Vienna; Writing by Mike Peacock and Luke Baker; editing by Janet McBride/Ruth Pitchford)