Germany, France draw battle lines over common bonds

BERLIN/PARIS (Reuters) - Germany dismissed a French-led call for euro zone governments to issue common bonds, a day before a European Union summit which investors are looking to for new measures to counter the bloc's debt crisis.

After a torrid week, stock markets rallied on optimism that the Wednesday summit would produce measures to foster growth and ward off the threat of contagion should Greece exit the euro.

The FTSEurofirst 300 index of top European shares closed up 1.9 percent and Spanish and Italian borrowing costs fell, leaving scope for disappointment if the EU leaders underwhelm.

New French President Francois Hollande will push a proposal for mutualising European debt at the informal summit, a scheme which many economists and policymakers say could be one of the most effective ways of restoring market confidence. Hollande has also called for a focus on growth rather than austerity.

But there is no sign that Germany, the EU's paymaster, led by Chancellor Angela Merkel, is ready to soften its opposition. Berlin says more progress is needed first on coordinating fiscal policies, a stance in which it has the backing of the Netherlands, Finland and Austria among others.

"Tomorrow's meeting will not deliver any landmark solution. The market is likely to be more prone to disappointment," said Matteo Regesta, a strategist at BNP Paribas.

A senior German official reiterated that Berlin did not believe jointly issued euro zone bonds were the solution and would not change its view, at least in the near term: "That's a firm conviction which will not change in June," the official said at a briefing. A second summit will be held in late June.

European economic commissioner Olli Rehn said the euro zone needed a roadmap spelling out specific integration steps that would eventually lead to joint debt issuance.

"We need to reflect what kind of European Union would be required to deepen economic and political integration, for instance, so that joint issuance of debt would make sense for all member states sharing the common currency," Rehn said in a speech to the European Parliament.

If euro zone nations ever manage to meet new fiscal rules demanding budget deficits of no more than three percent of GDP, then opposition to mutual debt issuance might melt away since national borrowing costs would presumably have converged too.

"In the very long term it may be a final chapter of a successful integration. That has always been the Dutch standpoint but it is not a solution to this crisis," Dutch Finance Minister Jan Kees de Jager said on television.

GROWTH MEASURES

The German official, speaking anonymously, also said he saw no need for leaders to discuss on Wednesday a loosening of deficit goals for struggling countries like Greece or Spain, or to explore new ways to recapitalize vulnerable banks.

With Greece holding an election on June 17, its second in as many months, which could hasten its departure from the euro zone if voters back anti-bailout parties, Merkel was put under some pressure at a weekend G8 summit in the United States. But she refused to budge on her insistence that any growth measures could not come via more deficit spending.

Without her agreement, no major policy shift will be possible.

The growth measures that are on the table - including boosting the paid-in capital of the European Investment Bank and plans for "project bonds" underwritten by the EU budget to finance infrastructure - will help. But most economists say they are nowhere near enough to turn the euro zone economy around.

The currency bloc appears to be heading back into recession having registered no growth in the first quarter.

Some major companies are feeling the pinch too.

British mobile phone operator Vodafone cut its medium-term sales target and took a writedown of 4 billion pounds ($6.3 billion) as cash-strapped customers in Spain, Italy, Greece and Portugal made fewer calls.

In its twice-yearly economic outlook, the Paris-based Organization for Economic Co-operation and Development forecast the 17-member euro zone economy would shrink 0.1 percent this year and said its debt crisis could still spiral out of control, with Greece struggling to remain solvent and Spanish banks needing to be recapitalized.

"The situation over the past few weeks has changed dramatically," OECD chief economist Pier Carlo Padoan told Reuters. "If the situation gets worse, there are ways to enhance the firewall capacity which could include a stronger intervention or role of the ECB."

MORE FROM ECB?

The OECD said the European Central Bank should not rule out buying government bonds again to keep borrowing costs down, lending directly to the ESM European bailout fund as well as cutting its main interest rate, which stands at 1.0 percent.

It could also consider another injection of liquidity into the banking system. The central bank's creation of more than 1 trillion euros ($1.3 trillion) of three-year money in December and February brought some temporary calm to the currency bloc.

As things stand, most of those options are opposed by at least some within the ECB governing council.

Speaking in London, International Monetary Fund chief Christine Lagarde said euro zone firewalls were a "work in progress".

Markets face an unsettling month before the Greek election and are also concerned about the shaky state of Spain's banking system and high debts. Madrid admitted on Friday its 2011 budget deficit was even higher than first thought.

Spain raised 2.5 billion euros in three- and six-month Treasury bills on Tuesday, the top end of the targeted range, at significantly higher yields than it paid investors for the same maturities a month earlier.

Greece, the cradle of the debt crisis, will recapitalize its four largest commercial banks to the tune of 18 billion euros, a senior banker said.

The funds, which will come from the euro zone's EFSF rescue fund, are needed to recapitalize Alpha Bank, National Bank of Greece, EFG Eurobank and Piraeus Bank, and will allow them to take liquidity funding from the ECB again, the banker said.

($1 = 0.6328 British pounds)

($1 = 0.7832 euros)

(Additional reporting by George Georgiopoulos, Angelika Gruber, Kate Holton and Emelia Sithole-Matarise; Writing by Mike Peacock; Editing by David Holmes and Alastair Macdonald)

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