Q+A: What ideas is Europe mulling to solve its debt

By John O'Donnell

BRUSSELS (Reuters) - Europe is working to ramp up the fire-power of its bailout fund amid growing alarm over its slow handling of a debt crisis that threatens to derail a global economic recovery, but European policymakers disagree over the best course of action.

Many of the options to bolster the 440 billion euro European Financial Stability Facility (EFSF) have catches, including opposition from countries like Germany, which fears a replay of its disastrous economic policies of the 1920s.

Meanwhile, euro zone officials played down reports on Monday of emerging plans to halve Greece's debts and recapitalize European banks to cope with the fallout, stressing that no such scheme is on the table yet.

HOW BIG MUST THE EURO ZONE FUND BE TO STOP THE CRISIS?

Rough calculations suggest the EFSF, which borrows its funds from the markets backed by guarantees from euro zone states, might cope with a bailout of Spain but that it would not have enough ammunition if Italy needed help.

The EFSF is already committed to providing 17.7 billion euros in emergency loans to Ireland and 26 billion to Portugal.

In addition, it takes over the remainder of Europe's contribution to an initial bailout of Greece, which is likely to require around 25 billion euros, and is expected to provide two-thirds of a 109 billion euro second bailout of Greece.

Taken together, the EFSF's current commitments total at least 142 billion euros, leaving it 298 billion euros.

A package for Spain might top 290 billion euros, according to some estimates, while a rescue bill for Italy could total almost 490 billion euros.

Some experts suggest doubling the EFSF. Others talk of boosting it to "several trillion." But the way to restore confidence, which will be determined by the reaction of stressed markets, goes beyond simple mathematics.

COULD TURNING THE EFSF INTO A BANK HELP?

One way of bolstering the EFSF's size, being proposed by the Center for European Policy Studies, a think tank in Brussels, is to turn it into a bank.

This means the Luxembourg-based vehicle could lend money to countries in difficulty and turn to the European Central Bank to refinance such loans rather than having to rely solely on its limited capital base.

Banks typically lend roughly 10 times their capital, and experts who have drawn up this model believe the EFSF could do the same.

That would mean the 440 billion euros of capital in the facility could in theory be transformed into more than 4 trillion euros of fire-power.

But the reality is not that simple. The EFSF would only qualify to receive credit from the ECB that was as good as the collateral, for example Spanish government bonds, that it has to offer.

If the EFSF buys these from the Spanish government directly, then a market discount to reflect the risk of default has to be applied, in addition to the standard haircuts the ECB charges for collateral. This reduces the amount of credit the EFSF could get from the ECB.

But it is political opposition rather than technical hitches that pose the biggest and perhaps insurmountable hurdle.

At the core of these are concerns recently aired by German Bundesbank chief Jens Weidmann that the ECB may already be overextending itself.

The euro zone's central banks and the ECB have a combined capital base of 82 billion euros. It has already lent 535 billion euros to banks and bought a further 150 billion euros of government bonds to prop up the market.

So far, Germany, the euro zone's chief paymaster, and the ECB are opposed to the idea, suggesting it has little chance of making it beyond the drawing board.

Last weekend, German finance minister Wolfgang Schaeuble said he was looking into alternatives.

WHAT OTHER SCHEMES COULD BOLSTER THE EFSF'S FIRE-POWER?

One such alternative would be to use the EFSF to insure investors against future losses when they buy Italian or Spanish bonds.

The EFSF would issue "credit enhancements" for new bonds that could cover potential losses, cutting the risk for investors and making it easier for countries like Italy to tap markets.

Such a scheme would not help Greece, said Sony Kapoor, a financial expert who has advocated the model, but would set up a "firewall" for Italy and Spain that would allow them tap money markets even if Greece were to default.

"This could take the form of the EFSF offering insurance against, say, the first 20 percent of any losses on these ... and would enable the EFSF to bring down the borrowing costs for Italy and Spain for the next 3 years or more," said Kapoor, the managing director of think tank Re-Define.

"Lowering the borrowing costs for Italy and Spain is a necessary step before any restructuring of Greek debt can be seriously contemplated."

"The options being discussed are primarily about policymakers, who believe that Italy and Spain are fundamentally solvent, calling the markets' bluff that they are not."

WHAT WOULD ACCELERATING THE INTRODUCTION OF A PERMANENT

MECHANISM ACHIEVE?

Unlike the current EFSF, the European Stability Mechanism (ESM) is permanent and has a pool of capital of 80 billion euros, paid in by countries in the same way as they do with the

ECB.

Starting the ESM in July next year, rather than July 2013 as planned, could reassure investors because it provides a second lever to support markets alongside the ECB.

But first, however, German chancellor Angela Merkel and other leaders have to convince national lawmakers to back their pledge to allow the EFSF to extend loans to countries under attack from markets or buy sovereign bonds to prop up struggling states.

(Additional reporting by Sakari Suoninen in Frankfurt and Annika Breidthardt in Berlin)