Selloff raises stakes in Sarkozy-Merkel euro zone talks

By Leigh Thomas and Yann Le Guernigou

PARIS (Reuters) - France and Germany's leaders face a stark choice in talks Tuesday over whether to steer the embattled euro zone toward closer monetary union or risk watching the bloc unravel.

French President Nicolas Sarkozy and German Chancellor Angela Merkel meet in Paris to discuss what further measures they can take to contain Europe's debt crisis, which is now spreading to the continent's core.

Italy has been forced to ramp up its austerity measures and financial market jitters hit France last week with French banks' shares subject to panic selling on rumors that the country could be next to lose its prized AAA debt rating.

Many experts say the only way to ensure affordable financing for the bloc's most financially distressed countries would be for the euro area to issue joint eurobonds -- although officials in Paris and Berlin said Tuesday's talks would not address that possibility.

Although the German government has long opposed the idea, support is beginning to emerge, with the country's export association saying Monday that all other means of fighting the crisis had run out.

Italian Economy Minister Giulio Tremonti said Saturday that eurobonds would be the best solution to Europe's debt crisis, and some economists say that the euro zone will inevitably come around to accepting the idea.

"EURO ZONE COLLAPSE"

French economist Jacques Delpla, who co-authored a paper proposing how eurobonds could work, said the euro zone faced collapse unless leaders went beyond an agreement reached at a July 21 emergency summit on the debt crisis.

"If we just stick to the July 21 agreement then, before the end of the year, there will be no euro zone, unless the ECB buys everything that's problematic."

Eurobonds aside, Sarkozy and Merkel will focus on proposals to improve the euro zone's economic governance, which they told fellow leaders in the bloc at last month's summit that they would issue by the end of August.

In particular, they could discuss holding regular euro zone summits, as France has long sought, or ways of improving peer monitoring of fiscal policies.

At the July summit, euro zone leaders agreed to a second bailout package for Greece and to give their European Financial Stability Facility rescue fund broader powers, but the moves provided only a brief respite in the debt crisis.

Economist Frederic Bonnevay at French think-tank Institut Montaigne said more radical measures were needed even if they did not include eurobonds for now.

"The size and powers of the EFSF need to be expanded dramatically -- that's a secret to no-one," he said, suggesting that its firepower should be raised to as much as one trillion euros from 440 billion euros ($635 billion) currently.

Sarkozy, who broke off his summer holiday last week to deal with the market meltdown in French stocks, is to meet with Prime Minister Francois Fillon over lunch to fine tune France's position before he meets Merkel from 1400 GMT (10 a.m. EDT).

A joint news conference is due at 1600 GMT.

(Additional reporting by Nicholas Vinocur and Patrick Vignal; Editing by Jon Boyle)