Merkel expects breakthrough on euro zone crisis Wednesday (Reuters)

BRUSSELS (Reuters) – German Chancellor Angela Merkel said she expected a breakthrough in efforts to come up with a comprehensive response to the euro zone debt crisis on Wednesday, after EU finance ministers made progress in talks on recapitalizing banks.

"We have to take far-reaching decisions. These have to be prepared properly, I believe that the finance ministers made progress, so that we can achieve our ambitious targets by Wednesday," Merkel told reporters.

Euro zone countries are working on a plan that involves leveraging the euro zone bailout fund, recapitalizing European banks and putting together a second financing package for Greece that entails deeper losses for private investors.

Euro zone leaders hope the measures will ease market anxiety over euro zone sovereign debt and put an end to the two-year-old crisis that now threatens the global economy.

Euro zone leaders meet on Sunday to discuss the package but real decisions will only come at the next summit on Wednesday.

"The breakthrough... will be on Wednesday," Merkel said.

(Reporting By Ilona Wisenbach, writing by Jan Strupczewski)

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Rating cut puts Spain back on crisis radar (Reuters)

MADRID (Reuters) – Standard & Poor's cut Spain's credit rating Friday, sending the euro briefly lower and underlining the challenges facing Europe's major powers as they meet G20 counterparts over the euro-zone debt crisis.

S&P, whose move mirrored that by fellow ratings agency Fitch last week, cited high unemployment, tightening credit and high private-sector debt among reasons for cutting the nation's long-term rating to AA- from AA.

Spanish 10-year government bond yields rose slightly in response, although they remained almost 60 basis points lower than those of Italy and, at 5.27 percent, some distance from the 7 percent level widely regarded as unsustainable.

"Despite signs of resilience in economic performance during 2011, we see heightened risks to Spain's growth prospects due to high unemployment, tighter financial conditions, the still high level of private sector debt, and the likely economic slowdown in Spain's main trading partners," S&P said.

It also noted the "incomplete state" of labor market reform and the likelihood of further asset deterioration for Spain's banks, and downgraded its forecast for Spanish economic growth in 2012 to about 1 percent, from the 1.5 percent it forecast in February.

High yields on Spanish government bonds point to concerns that it could be the next euro zone economy to require a Greece-style bailout, and despite an unpopular austerity program, doubts remain that Spain will meet its deficit target of 6 percent of GDP this year.

The Financial Times quoted a senior Spanish official as saying that meeting the 6 percent deficit target would be "difficult."

But Spain's Economy Minister Elena Salgado said later on Friday that there would be some margin for maneuver this year thanks about 2 billion euros raised by an auction of wireless frequencies and lower interest payments.

"Interest payments by the central government will be at least 2 billion euros below budget. So the combined effect of the spectrum auction and lower interest payments will mean we have a margin of 0.4 percent (of GDP)" Salgado said.

BETTER PIIGS

S&P announced the downgrade as finance ministers and central bank chiefs from the world's 20 biggest economies were due to meet later Friday in Paris amid pressure to find an urgent and convincing solution to the deepening debt crisis.

Spanish unemployment, at 21 percent, is the highest in the European Union, reflecting a stagnant economy, the collapse of a decade-long housing boom and cuts aimed at taming a public sector deficit that reached 11.1 percent of GDP in 2009.

The decision to shelve multi-billion-euro privatization plans, mainly due to tough market conditions, has meanwhile deprived the state of much needed revenues.

"The market's perception of Spain is that it's in a stronger position (than other debt-laden states) - with a strong defense on bank capitalization in place from the FROB bad bank fund, aggressive government action to control and cut spending and a 70 percent debt/GDP ratio," said Bill Blain, senior director at broker NewEdge Group.

"The biggest problem, but the issue I read least about, is the unresolved crisis between central government making cuts and the reticence of regions to follow," he said.

Salgado said the government will shortly announce its plans to ensure Spain's heavily-indebted regions meet their tough 2011 deficit targets.[nE8E7L700E]

JOB DILEMMA

A botched labor market reform in 2010 did little to alleviate joblessness that is concentrated mainly amongst younger Spaniards, and a new government after November 20 general elections will be under pressure to tackle the issue.

The center-right People's Party is expected to win the election easily and deepen austerity measures but they have shied away from presenting specific policy measures for fear of eroding public support.

Like Fitch, which also now rates Spain at AA-, S&P signaled further possible downgrades for Spain, saying there was still a risk the euro zone's fourth-largest economy could slip into recession next year, with a 0.5 percent contraction.

The euro reached a session low of $1.3723 after the downgrade, but later recovered on reports the European Central Bank was buying Spanish and Italian debt.

Hopes that G20 officials would agree on the outlines of a plan to resolve the debt crisis ahead of a European Union summit on October 23 also buoyed the shared currency, which remained on course for its biggest weekly rally since January.

Spain's blue chip index was little affected by the rating cut.

Finance chiefs from outside the euro zone are expected to speak frankly when they meet their European counterparts at Friday's G20 meeting, given impatience growing over the crisis and its implications for the rest of the world.

Thursday, Fitch cut credit ratings or signaled possible downgrades for several major European banks. It downgraded UBS and Royal Bank of Scotland. It also placed Barclays Bank, BNP Paribas, Credit Suisse, Deutsche Bank and Societe Generale on watch negative.

(Reporting by Balazs Koranyi, Mark Bendeich, Elisabeth O'Leary and Judy MacInnes; Editing by Catherine Evans and Patrick Graham)

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U.S. rejects plan to strengthen IMF in euro zone crisis (Reuters)

PARIS (Reuters) – Proposals to double the size of the IMF as part of a broader international response to Europe's debt crisis immediately ran into resistance from the United States and others, burying the idea for now and firmly putting the onus back on Europe.

The outlines of the plan, that had the backing of several developing economies, emerged as G20 finance ministers and central bankers began meeting in Paris to discuss a world economy under threat from European nations mired in debt.

One G20 source said some policymakers backed injecting some $350 billion into the International Monetary Fund. Other options under consideration included loans, special purpose vehicles and note purchase agreements.

Treasury Secretary Timothy Geithner wasted no time in shooting the idea down. The IMF's dominant shareholders, including the United States, Japan, Germany and China, are content that the fund's $380 billion worth of resources is enough. Canada and Australia also voiced opposition.

"They (the IMF) have very substantial resources that are uncommitted," Geithner said.

The United States is among countries keen to keep pressure on the Europeans to act more decisively to end the two-year-old debt crisis that began in Greece but has since spread to Ireland and Portugal and is lapping at Spain and Italy.

"The first priority here is for Europeans to put their own house in order," Australian Finance Minister Wayne Swan said.

The finance ministers of France and Germany, under pressure from the rest of the world to act in concert, made a fresh commitment to have a plan for the euro zone in place before a summit of G20 leaders in Cannes on Nov 3/4.

Speaking after a lunch meeting with President Nicolas Sarkozy, French Finance Minister Francois Baroin said: "We will continue our discussions in the coming days but we have already come to some agreements that will be very important."

If minds needed concentrating further, the downgrade of Spain's credit rating a few hours earlier highlighted the risk of a much larger economy than Greece coming under threat.

Standard and Poor's cut Spain's long-term credit rating, citing the country's high unemployment, tightening credit and high private sector debt.

French and German officials are trying to put flesh on the bones of a crisis resolution plan in time for a European Union summit on October 23. Fears about the damage a default by Greece -- and possibly others -- could inflict on the financial system have driven a confidence-sapping bout of market volatility since late July, with global stocks falling 17 percent from their 2011 high in May.

Canadian Finance Minister Jim Flaherty also said the G20 should keep up pressure on the euro zone on its "arduous" journey toward a solution and not focus on IMF resources.

DIVISION

Unlike in 2009 when the G20 launched coordinated stimulus to pull the world out of crisis, the rest of the world is chafing at Europe's slow response while Washington and Beijing are sparring over the yuan currency.

The Franco-German crisis plan is likely to ask banks to accept bigger losses on their Greek debt than the 21 percent spelled out in a July plan for a second bailout of Athens, which now looks insufficient.

"It will be more, that's more or less certain," French Finance Minister Francois Baroin said.

It should also lay out a system for recapitalizing banks and plans to leverage the euro zone's European Financial Stability Facility to give it more punch.

Japanese Finance Minister Jun Azumi said he would share with his G20 counterparts Japan's "bitter experience" of failing to contain its 1990s banking crisis by doing too little, too late.

Whilst the EFSF has the resources to cope with bailouts for Greece, Portugal and Ireland, it would be overwhelmed by the need to rescue a bigger economy such as Italy or Spain.

"We see heightened risks to Spain's growth prospects due to high unemployment, tighter financial conditions, the still high level of private sector debt, and the likely economic slowdown in Spain's main trading partners," S&P said.

The most effective method would be to turn the EFSF into a bank so it could draw on European Central Bank resources. Both Germany and the ECB are opposed to that.

The G20 may refer to the euro crisis in its communique and in closing news conferences on Saturday evening, but little else of substance is likely to be inked in with a EU summit in nine day's time the make-or-break moment.

ROLE OF IMF

G20 sources said most BRICS economies were in favor of bolstering the IMF's capital as a crisis-fighting tool.

"We have said this before and have conveyed this again, that if emerging economies and the BRICS are called upon to contribute, we can do it via the International Monetary Fund," one of the sources said. "India is open to it, China and Brazil are also okay with the idea."

Another G20 source said the IMF would present a plan which had broad support to its executive board to make short-term credit lines available to fundamentally healthy countries hit by liquidity crises. It could aid euro zone countries hit by the current crisis of confidence in the bloc's sovereign debt.

The Paris meeting may give the green light to regulators for new rules on banks deemed 'too big to fail', including capital surcharges, due to be officially approved in Cannes.

Any real progress on bigger goals such as setting parameters to measure global imbalances and reining in speculative capital flows is unlikely to come before a November 3-4 summit in Cannes, where France passes the G20 baton to Mexico.

A French finance ministry source said that for Cannes, France hoped to have two or three measures agreed for countries showing imbalances: consolidation measures for those with high deficits and stimulus measures for those with surpluses.

"We are going to try to make some progress and obtain, perhaps not tomorrow or Saturday but by Cannes, a list of measures country by country," he said. "These must be measures which will have an impact on the real economy."

A separate G20 source said after preparatory talks late on Thursday that China would commit in Paris to boost its consumption through a five-year plan, via households and companies as well as infrastructure.

The G20 countries make up 85 percent of global output.

An April G20 meeting placed seven large economies under review -- the debt-burdened United States, export driven China and the economies of France, Britain, Germany, Japan and India. Officials have said privately the aim was to get Beijing to discuss the yuan, and China's cooperation is essential to the success of the process.

China and the United States sparred this week over a U.S. Senate bill to press Beijing to raise the yuan's value, and the issue is likely to create a sideshow at the G20 talks, even if the euro zone crisis pushes it off center stage.

(Additional reporting by Daniel Flynn, Francesca Landini, Randall Palmer, David Milliken, Kevin Yao; Writing by Mike Peacock/Janet McBride)

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Analysis: Europe puts its head in sand over growth crisis (Reuters)

By Alan Wheatley, Global Economics Correspondent Alan Wheatley, Global Economics Correspondent – Mon?Sep?5, 4:19?am?ET

LONDON (Reuters) – Japanization is shorthand for slouching toward that country's noxious mix of low growth and high debt. Euro zone governments will find it tough to keep the ugly new word out of their lexicon.

Concern is mounting over a deterioration in Europe's long-term growth prospects that, unaddressed, will make it even harder to tackle the banking and debt problems underlying the current life-or-death struggle over the euro.

The financial crisis that has been rocking the global economy since 2008 has permanently reduced trend growth across the industrial world. The Organization for Economic Cooperation and Development in Paris reckons the potential output of its 34 member countries has dropped by about 2.5 percent.

"A lot of countries are going to take a permanent hit to their trend rate of growth. This is not an ordinary recession and so we're not going to see countries bouncing back to pre-crisis rates of growth," said Philip Whyte, a senior research fellow at the Center for European Reform, a London think-tank.

As firms have gone bust, capacity has been lost for good. With demand subdued, profitable companies are not replacing old plants.

And as high unemployment persists, skills atrophy. This weakens productivity and shuts people out of the job market for longer and longer periods -- a danger stressed by Federal Reserve Chairman Ben Bernanke at the U.S. central bank's Jackson Hole symposium last month.

Apart from sapping animal spirits and forcing governments to raise taxes or cut spending, diminished growth closes off one route for lowering the high sovereign debt to gross domestic product ratios that have locked Greece, Ireland and Portugal out of the bond markets and are unnerving investors in Italian and Spanish debt.

Against this background, and with the scope for fiscal and monetary stimulus all but exhausted, politicians might be expected to grasp the nettle and push through reforms to improve the supply side of the economy -- policies such as making it easier to hire and fire, promoting greater competition and investing more in training.

Far from it. Pier Carlo Padoan, the OECD's chief economist, says he is less optimistic about the prospects for deep-seated change than he was at the start of the year.

"I see that measures are being announced. I would like to see them being implemented," Padoan said.

With policy ammunition running desperately short, he said it was time for governments to overcome their squeamishness about confronting vested interests opposed to change. "This is a luxury that many countries cannot afford any more. The situation does not allow it."

SOUTHERN DISCOMFORT

The vicious circle of rising debt and falling growth is made worse by the fact that those countries drowning in debt on the periphery of the euro zone are also the ones that have dragged their feet on freeing up their product and labor markets or modernizing their education systems.

"They're going through some truly horrible times. I'm very worried about the whole southern European fringe, not just on an 18-month to 2-year view but looking out a decade or longer," said Whyte with the Center for European Reform.

Germany, by contrast, derided a decade ago as the sick man of Europe, is being held up as a model, at least when it comes to jobs.

"The remarkable resilience of the German labor market in the last few years, where wage moderation and flexible time accounting shielded the economy from excessive job destruction, illustrates admirably the promise of well-structured reforms," Jean-Claude Trichet, president of the European Central Bank, said approvingly in Jackson Hole.

How much are countries missing out by not pressing the reform button?

Padoan says Europe's trend growth has fallen in recent years to an average of just 1.5 percent a year, but he says some members of the 17-nation euro zone could almost double that rate with a supply-side jolt.

Italy needs to liberalize its service sector, open up professions to new entrants and improve energy efficiency, Padoan said. Greece needs to do all that and overhaul its labor market and competition policy at the same time.

POOR ADVERT FOR FREE MARKETS

Germany, too, could grow faster still if it liberalized services, which would trigger increased investment.

These policy prescriptions are well worn. Leaders of the European Union enshrined them and a host of other reform goals in the 2000 Lisbon Agenda, which they promptly ignored. The pledges have since been repackaged as the Europe 2020 Strategy, but Whyte says the havoc wrought by the near-collapse of the international financial system will make politicians more wary than ever of the social disruption that reforms entail.

"The Great Financial Crisis hasn't been a great advert for free-market capitalism," said Whyte. His research outfit publishes a booklet this week exploring how Europe could take off by embracing innovation. But in this area, too, Whyte fears the political climate means policy is likely to be increasingly hijacked by incumbent firms hostile to competition from start-ups.

Europe is not doomed to go down Japan's path of economic stagnation. Its potential growth rate is low but stronger than Japan's -- estimated by the Bank of Japan at just 0.5 percent a year because of a fast-shrinking working-age population.

But the specter of a renewed recession is a reminder for governments that, even if they can spirit away the euro zone's currency and debt woes, they have still to find the elixir for growth.

"I'm not saying politicians will implement reform, but they should," Padoan said. "Some politicians resist reform because they are captive to interest groups. Well, the price for those governments in terms of sustainable growth will be very high."

(Reporting by Alan Wheatley; Editing by Ruth Pitchford)

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Analysis: Pension funds in new crisis as deficit hole grows (Reuters)

LONDON (Reuters) – Pension funds in developed economies are facing a new crisis as falling equities and tumbling bond yields widen their deficits, threatening the incomes and retirement dates of future retirees.

At the heart of their problems is a steady move by pension plans in the United States, euro zone, Japan and the UK to cut exposure to risk after the financial crisis.

But this "de-risking" may end up depressing their long-term returns from stock market investment and challenge the conventional wisdom that shares generate higher returns than bonds.

With weaker holdings and increased liabilities, companies will find it more difficult to fund existing pension schemes. They may cut new business investments as they use more cash to pay pensions.

For future pensioners, it means they will potentially face a lower retirement income and a longer working life -- or both.

This year has been a nightmare for many in the industry -- which controls $35 trillion, or a third of global financial assets -- and funding deficits are posting double-digit rises.

"We had a credit crisis and government bond crisis, and the third one we have is the pension crisis. This is the one where everything is going wrong and there's no obvious way out," said Kevin Wesbroom, UK head of global risk services at consultancy Aon Hewitt.

The sharp retreat in stocks through the summer has hurt them again by weakening their asset positions and threatening to erode stock market recoveries seen since the equity collapse surrounding the 2007-2009 credit crisis.

Even lower bond yields are proving to be a new headache.

"The real killer is liabilities are going up because in the flight to quality everyone gets out of equities and runs for cover in safe assets like government bonds, and yields are falling," said Wesbroom.

Many defined benefit(DB) pension plans -- where benefits are pre-determined -- pay a fixed stream of income to retirees.

The low-yielding environment makes it harder for the funds to meet these bond-like liabilities, forcing them to accumulate even more fixed income instruments to try to meet their obligations, creating a vicious circle.

FALLING YIELDS

Recent data on pension deficits highlight the plight of many pension funds.

In the United States, funding deficits of the 100 largest DB plans rose $68 billion to $254 billion in July, according to the Milliman Pension Fund Index. July marked the 10th largest deficit rise in the index's 11 year history.

Even if these companies were to achieve an optimistic annual return of as much as 8 percent and keep the current benchmark yield of 5.12 percent, their funding status is not estimated to improve beyond 93 percent by end-2013 from the current 83 percent.

Aon Hewitt estimates deficits of DB pension plans for FTSE 350 companies as of end-August rose 20 billion pounds from July to a 2011 high of 58 billion pounds. Their funding ratio stands at 89.8 percent, down from 94.1 percent three years ago.

The drop in the funding ratio is driven by a rally in the fixed income market. In Europe, the double-A rated corporate bond yield -- one of the benchmark rates used by regulators -- fell 300 basis points in the last three years to 3.55 percent, according to Barclays Capital.

The widely used rule of thumb is that a 50 basis points fall in the discount rate roughly results in a 10 percent increase in liabilities.

"Things look substantially worse now than they were during the credit crisis," said Pat Race, senior partner at investment consultancy Mercer.

In reaction to the past few years of an equity decline and volatility, many pension funds are indeed planning to buy more bonds, a move highlighted by Mercer's survey of over 1,000 European DB pension funds in May.

"Trustees do want to de-risk but financial directors have irrational desire to have equities. They are too wedded to equity markets," Race said.

"You still have massive uncertainties with a potential for another dip into recession. I don't see any reversion to days when equities are dominant part of DB plans."

JP Morgan's data shows pension funds and insurance companies in the United States, euro zone, Japan and UK bought $173 billion of bonds in the first quarter, boosting their bond buying for the third quarter in a row.

At the same time, they cut equity buying for a fifth quarter in a row, selling $22 billion of stocks in Q1.

In Europe, pension funds slashed their weightings for equities to an average of 31.6 percent in 2011 from 43.8 percent in 2006, while fixed income holdings rose to 54 percent from 47.8 percent in the same period, according to Mercer.

EQUITY PREMIUM PUZZLE

Growing pension funds deficits on corporate balance sheets may make it more difficult for companies to access credit and discourage firms which are already hoarding cash from spending cash to expand business.

For wider financial markets, the giant industry's gradual move away from stocks could hit equity risk premium -- excess return of equities over risk-free securities which compensates investors for taking on the relatively higher risk.

This may reinvigorate an academic debate where some economic analysis suggests the equity risk premium should be small, in most cases less than half a percentage point, as opposed to the widely-used range of 4-6 percent.

Indeed, 10-year U.S. Treasuries gave higher total returns in the past 10 years on a rolling basis than world stocks. http://link.reuters.com/nyv53s

"The puzzle... is that for the past 20 years, there has been no net equity risk premium. With the recent sell-off in risk and the rally in bonds, I think there might have been a net premium on bonds," Stephen Jen, managing partner at SLJ Macro Partners, said in a note to clients.

"This has turned financial theory on its head, and managers of pension funds and sovereign wealth funds need to think about this very carefully."

(Editing by Anna Willard)

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Debt crisis resists assault by ECB and global leaders (AFP)

FRANKFURT (AFP) – World leaders scrambled Monday to ensure financial and economic stability as the European Central Bank bought eurozone bonds to stem a spiralling debt crisis, but chronic doubts endured and battered markets tumbled again.

Finance ministers and central bankers from the Group of 20 industrialised and emerging economies pledged to "take all necessary initiatives in a coordinated way to support financial stability and to foster stronger economic growth in a spirit of cooperation and confidence."

Their statement came after Asian stock markets suffered heavy losses and European trade saw promising gains melt by noon, with Friday's unprecedented US ratings downgrade adding to the toxic cocktail.

A sharply-worded editorial in the Chinese People's Daily -- the mouthpiece of China's Communist Party -- said Western nations threatened global well-being by "ignoring their responsibility" to the rest of the world.

The G20 stressed that its members would maintain constant contact "to ensure financial stability and liquidity in financial markets."

Earlier, the Group of Seven (G7) industrialised countries -- Britain, Canada, France, Germany, Italy, Japan and the United States -- made a similar commitment.

Sentiment on major European financial markets took a stab at resisting the downward trend before throwing in the towel and heading firmly south as well.

Economists warned that even the long-awaited ECB intervention on bond markets was no "silver bullet" and that big obstacles remained to stabilising strained public finances and putting credible eurozone defence mechanisms in place.

The G7 and G20 statements came after a whirlwind of weekend conference calls between political leaders and officials who saw storm clouds hovering over the markets.

The moves were part of a global response dictated by Standard & Poor's taking the historic step of cutting its US credit rating to AA+ from the top notch triple-A late on Friday.

As Europe struggles with its problems, global markets also want to know how Washington will reduce its more than $14 trillion debt without choking off an economic recovery since a modest US debt deal.

Late Sunday, the ECB said it would "actively implement" a programme that buys eurozone bonds, a measure which seemed to be working Monday, at least initially, as pressure eased on Italian and Spanish government debt.

That was also helped by Italy and Spain announcing measures to curb deficits and debt, and France and Germany pushing for full and rapid implementation of measures agreed at an emergency eurozone summit last month to protect the euro.

"However, we think it would be optimistic to assume that this response will be sustained or that the bond purchases will do much to address the eurozone?s fiscal crisis," Capital Economics chief economist Jonathan Loynes said.

Asian stock markets were the first to give a group reaction to the US downgrade and prospect of a serious global economic slump.

Tokyo shed 2.18 percent, Hong Kong lost 2.11 percent, Sydney fell 2.91 percent, Seoul sank 3.82 percent and Shanghai lost 3.55 percent.

In Europe, stock markets initially showed signs of resilience but later began a slide that accelerated once Wall Street opened.

London's FTSE-100 index closed down 3.39 percent to 5,068.95 points, while in Frankfurt the DAX dropped 5.02 percent to 5,923.27 points. In Paris, the CAC-40 slid 4.68 percent to 3,125.19 points.

Markets in Madrid and Milan initially bounced higher as news of the ECB's intervention, but they also got caught up in the sell off, losing 2.44 percent and 2.43 percent respectively.

Safe-haven gold surged to a record $1,715.75 per ounce, before finishing the day at $1,693. The euro slid to $1.4234 from $1.4282 on Friday.

On Wall Street, the Dow Jones Industrial Average was down 2.9 percent in afternoon trading at 11,109.93 points.

The broader S&P 500 dropped 3.8 percent to 1,153.74 points, while the tech-heavy Nasdaq Composite plunged 4.0 percent to 2,432.30 points.

Analysts said dissension among ECB governors on the bond purchases could curb the intervention and Commerzbank analyst Bernd Weidensteiner added: "In principle, the crisis can probably only be tackled by reducing deficit and stabilising debt levels. But this needs time."

IHS Global Insight chief economist Howard Archer said the ECB was building an essential firewall for Madrid and Rome but could not be content with "half-hearted measures in exercising its function as ?true lender of last resort? - the markets need to be absolutely convinced."

Deutsche Bank economist Gilles Moec said the focus would now shift to the lending capacity of the European Financial Stability Facility (EFSF), the eurozone's rescue fund that is too small to bail out Italy or Spain if they go the way of Greece, Ireland and Portugal.

But a German government spokesman said there were no plans to boost the 440-billion-euro ($625-billion) EFSF, which is supposed to take over bond buying from the ECB as soon as possible.

The ECB is the only European institution capable of acting fast and keeping at bay so-called bond vigilantes who strike fear into finance officials.

But Barclays Capital economists warned that it might be hard to buy enough government debt to keep the pressure off for long.

Goldman Sachs economists estimated the ECB would have to purchase at least 100-130 billion euros worth of Italian and Spanish bonds, compared with the total amount it had held until now of 74 billion euros.

Italy, the eurozone's third largest economy, saw its borrowing costs hit record highs last week.

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Market rout deepens global economic crisis (Reuters)

BEIJING/SINGAPORE (Reuters) – The global economy stumbled deeper into crisis as stock markets slumped further on Tuesday, with investors losing confidence that the United States and Europe can rein in their debt burdens quickly and avert a double-dip recession.

Even as Asian equity markets pulled back from another day of staggering losses as they closed, European shares tumbled for an eighth session running, with news of an unexpected drop in British factory output in June highlighting the weakness of the economy.

The worsening market trauma has piled pressure on the U.S. Federal Reserve to announce fresh measures of support for the U.S. economy at a regular policy meeting on Tuesday, but analysts said its options are limited.

"You have got to a situation of capitulation and panic selling, and these things will keep running until we get some sort of policy response," said Peter Hickson, managing director of global commodity research at UBS.

"Even policy response these days seems to be impotent in terms of the market sentiment at the moment. The market is asking whether policymakers have many more bullets to fire."

Investors fear that, with confidence in the global economy's prospects evaporating, financial markets will remain in a slump, feeding a vicious circle of pessimism.

As of Monday, stock losses had wiped some $3.8 trillion from investor wealth globally in the recent rout as buyers rushing for perceived safety in the Japanese yen, the Swiss franc and gold, which hit another record high on Tuesday.

MSCI's all-country world index was down 1.2 percent, and has now shed about 20 percent since peaking in May. The market rule of thumb is that a fall of that magnitude constitutes a "bear market".

CHINA INFLATION DASHES STIMULUS HOPES

As the flight from risk continued in Asia and Europe on Tuesday, there was more bad news, this time from China, the stuttering global economy's main engine room.

Official data showed China's industrial output grew at a slower pace and its annual inflation rate unexpectedly quickened to 6.5 percent in July.

The inflation pressure puts the country's central bank in a bind as it tries to keep prices in check without dragging down an economy that already faces increasing threats from abroad.

It may not be in a position to reprise its 2008 role of lifting the global economy. When the Lehman Brothers bankruptcy triggered a worldwide slump, China implemented a stimulus package that helped buffer its own economy and buoy the world.

However, some analysts called on Beijing to act.

"It's time for Beijing to announce to the whole world that it will try to stimulate domestic demand again," said Tang Yunfei, an analyst with Founder Securities in the Chinese capital.

Global leaders have failed to reverse sliding markets since a blow was dealt to investor confidence by Standard and Poor's downgrade of the U.S. sovereign credit rating last week.

The downgrade heightened concerns that the twin-pronged crisis of a worsening euro-zone debt problem and a faltering U.S. economy raised the risks of a double-dip recession.

The European Central Bank (ECB) swept into the bond market to buy Italian and Spanish debt and sling a safety net under the euro zone's third- and fourth-largest economies on Monday. But bickering has persisted in Europe over a longer-term rescue plan.

In the United States, President Barack Obama called on Monday for urgent action on the U.S. budget deficit, but his proposal on taxes was promptly rebuffed by Republicans.

A pledge by G7 finance ministers and central banks on Sunday to provide extra cash if markets seize up has also provided little solace as their credibility wore thin.

"CREDIBILITY DEFICIT"

"Four years into the financial crisis, it is becoming increasingly clear that the biggest deficit is not in credit, but credibility," Harvard University economist Kenneth Rogoff wrote in the Financial Times.

"Markets can adjust to a downgrade of global growth, but they cannot cope with a spiraling loss of confidence in leadership and a growing sense that policymakers are disconnected from reality."

Major indexes in Asia slumped in early trade following a drop of more than 6 percent on Wall Street on Monday, and although some staged a sharp rebound, Hong Kong shares recorded their biggest one-day decline since the 2008 crisis.

European bourses put in a short-lived attempted at gains at the open, but succumbed to the bearish mood. The FTSEurofirst 300 index of top European shares lost ground for the eighth session in a row, hitting a two-year low.

"The speed and degree of deterioration in the situation is akin to what we saw during the failure of Lehman Bros, through the dot.com burst ... and during the 1982 recession," said Warren Hogan, chief economist at ANZ Banking Corp in Australia.

"We are looking at markets pricing for some sort of financial crisis. I think we are at a critical period now."

Concerns mounted that Asia would inevitably feel the cold wind of the West's slowdown.

"This is the first time in several years that all three major economic regions are feeling economic distress at the same time," said Keith Ducker, chief investment officer of Tora, a dark pool operator.

FOCUS ON THE FED

With U.S. stock index futures pointing to further steep losses for Wall Street on Tuesday, attention focused on a meeting due later of the Federal Open Market Committee as a possible prop for the market, though the Fed is expected to keep interest rates unchanged.

"Speculation is growing that Chairman Ben Bernanke may do more to help restore confidence with possibly another round of asset purchases," said Philippe Gijsels, head of research at BNP Paribas Fortis Global Markets, in Brussels.

On the political front, Obama said on Monday he hoped the loss of the prized AAA credit rating would add urgency to U.S. budget cutting plans.

He called for both tax hikes and cuts to welfare programs as part of the $1.5 trillion in deficit reduction that a special committee would deliver in late November, but Republican House Speaker John Boehner once again rejected the call, saying tax hikes were "simply the wrong approach."

Obama also spoke with the leaders of Italy and Spain, welcoming measures by their governments to address the economic turmoil in Europe.

Traders said the ECB was again seen buying Italian and Spanish debt on Tuesday after it agreed on Sunday to broaden its bond-buying program for the first time to halt an attack on the Mediterranean countries. Italian and Spanish yields declined sharply.

The ECB move was seen as only a temporary solution, however, due to the sheer size of Italy's bond market -- $1.6 trillion -- and there are doubts in the market it can be sustained.

(Editing by Lincoln Feast)

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EU says capacity to solve debt crisis in doubt (Reuters)

BRUSSELS/ROME (Reuters) – The European Union acknowledged on Wednesday that investors now doubt whether the euro zone can overcome its debt crisis and Italy's Silvio Berlusconi called for more action to ward off market attacks.

European Commission President Jose Manuel Barroso said a surge in Italian and Spanish bond yields to 14-year highs was cause for deep concern although they did not reflect the true state of the third and fourth largest economies in the currency area.

"In fact, the tensions in bond markets reflect a growing concern among investors about the systemic capacity of the euro area to respond to the evolving crisis," Barroso said in a statement.

He urged member states to speed up parliamentary approval of crisis-fighting measures agreed at a July 21 summit meant to stop contagion from Greece, Ireland and Portugal, which have received EU/IMF bailouts, to larger European economies.

But neither he nor European Monetary Affairs Commissioner Olli Rehn offered any immediate steps to stem the crisis, which has flared again with full force less than two weeks after that emergency meeting.

Italy has borne the brunt of a selloff triggered by the unresolved debt crisis and fears of a global economic slowdown.

"Our country has a solid political system ... we have solid economic fundamentals. Our banks are liquid, solvent and they've easily passed the European stress tests," Prime Minister Berlusconi, who has been largely silent, closeted with his lawyers over several ongoing trials, told parliament.

"The markets didn't reflect, and still don't reflect the importance of (European) interventions that have been taken. So it's essential to give certainty to markets," he said.

Italian Economy Minister Giulio Tremonti held two hours of emergency talks with the chairman of euro zone finance ministers, Jean-Claude Juncker, in Luxembourg but neither disclosed anything of substance after the meeting. Tremonti also conversed with Rehn.

A European Commission spokeswoman said there had been no discussion of a bailout for Italy, which would overwhelm the bloc's existing rescue funds.

The market turmoil caused alarm in some parts of Europe but apparent insouciance in the bloc's biggest economy, Germany.

"Italian and Spanish bond yields rose to their new record highs. This is a very alarming and scary thing," Finnish Prime Minister Jyrki Katainen told public broadcaster YLE. "The whole of Europe is in a very dangerous situation."

With many policymakers on holiday, there seemed little prospect of early European policy action, although euro zone governments were in telephone contact about the situation.

German Economics Minister Philipp Roesler said Italy and Spain were not even discussed at Berlin's weekly cabinet meeting which he chaired in place of Chancellor Angela Merkel, who is on vacation and did not call in.

A German government spokesman said Berlin saw no reason for alarm over the selloff of Italian stocks and bonds and was focused on implementing the latest euro zone summit decisions.

In stark contrast, Spanish Prime Minister Jose Luis Rodriguez Zapatero delayed his holiday and held crisis talks with ministers ahead of a crucial bond auction on Thursday.

The euro zone's rescue fund cannot use new powers granted at last month's summit to buy bonds in the secondary market or give states precautionary credit lines until they are approved by national parliaments in late September at the earliest.

The European Central Bank could reactivate its bond-buying program, which temporarily steadied markets last year but has been dormant for more than four months. Weekly data released on Monday show it has so far refrained from doing so despite market rumors to the contrary last week.

Italy and Spain could offer new austerity measures to try to placate the markets, but Rome has just adopted a 48 billion euro savings package and Madrid's lame duck government has just called an early general election for November 20.

BANK SHARES HAMMERED

Shares in banks exposed to euro zone sovereigns, particularly in Italy, have taken a hammering and are having growing difficulty in securing commercial funding.

"Bank funding remains stressed for southern Europe and remains a key source of risk for bank earnings, ability to lend and a drag on economic recovery," Huw van Steenis, analyst at Morgan Stanley in London, said in a note. "The risk of a credit crunch in southern Europe is growing."

Italian bank shares rebounded after data showed the Italian services sector contracted by less than expected in July. Shares in Unicredit, among those pummeled in the latest round of the crisis, rose 2 percent after Italy's biggest bank easily beat second-quarter net profit forecasts.

But the ripples continue to spread.

France's Societe Generale warned investors it may miss its 2012 profit target after taking a 395 million euro pretax charge in the second quarter on its exposure to Greek debt. Its shares plunged by nearly 10 percent.

The Swiss National Bank cut its interest rate target and said it would very significantly increase its supply of liquidity to try to bring down the value of the Swiss franc, which it said has become massively overvalued.

The currency has served as a refuge, along with gold, amid market turbulence driven by anxiety over a slowing U.S. economic recovery and Europe's debt crisis.

Worries about Italy, the euro zone's second biggest debtor, have been exacerbated by political instability in Berlusconi's fractious center-right coalition. Despite the austerity plan, doubts have lingered about a weakened government's ability to enforce the cuts, and about the lack of structural reforms to boost Italy's miserable growth rate.

"For both Spain and Italy, the 7 percent level in yields is the one everyone is focused on," said West LB rate strategist Michael Leister. "Although we're still quite a decent amount away from that, any break of the 6.50 percent level is going to be a catalyst to get to those higher rates."

On Wednesday, Spanish and Italian 10-year yields stood respectively at 6.27 and 6.10 percent. The gap between them has narrowed as Italy has overtaken Spain as the main focus of market concern about debt sustainability.

(Additional reporting by Kirsten Donovan, Swaha Pattanaik and Alex Chambers in London, Gernot Heller in Berlin, Katie Reid in Zurich; writing by Paul Taylor/Mike Peacock; editing by Janet McBride)

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Analysis: World poorly placed to meet new economic crisis (Reuters)

LONDON/FRANKFURT (Reuters) – With financial markets in turmoil and economic growth slowing, policymakers around the world may once again be forced to cooperate to try to head off a crisis, as they did successfully in 2008-2009. But this time, they have fewer good options.

Central banks have less room to ease monetary policy than they did three years ago; cash-strapped governments cannot afford to boost spending as much; and political disarray in some countries may make concerted global policymaking harder.

"What can you do? On monetary policy, clearly no one agrees with anyone. On fiscal policy, everyone is blocked," said Deutsche Bank economist Gilles Moec.

By some measures, the global situation is not nearly as bad as it was in 2008. Banks have strengthened themselves since the collapse of Lehman Brothers and the world is still far from a recession; JPMorgan may have cut its forecast for 2012 U.S. growth this week but it still expects an expansion of 1 percent.

Global stocks have dropped nearly 10 percent in the last month but MSCI's world equity index is still 90 percent above its 2009 low.

"I know people are saying that this feels very much like 2008 but I don't think we are there. In 2008, you could point at the problem in the banking sector and there were failed banks," said Nomura economist Jens Sondergaard.

Still, the trends have clearly turned negative. National purchasing managers indexes around the world have dropped near or below the "boom or bust" threshold separating economic growth from contraction. This week's slide of British government bond yields to record lows underlines both investor nervousness and a grim growth outlook.

In some ways, the situation is more worrying than it was in 2008: There is widespread concern about the risk of a downgrade of the U.S. sovereign credit rating, and a bond market attack on Italy, the euro zone's third-biggest economy, has called into question the long-term viability of the zone. Valuations of U.S. and European bank shares are back around levels hit at the time of Lehman's collapse.

"The difference (between 2008 and now) is that this is not only a currency and banking crisis, you have now a currency, banking and sovereign crisis," said Sylvain Broyer, analyst at European financial firm Natixis.

The Swiss central bank's shock decision to cut interest rates on Wednesday to fight the rapid appreciation of the Swiss franc was seen by some analysts as a possible precursor to concerted efforts by central banks in the Group of 20 nations to stabilize markets.

Steen Jakobsen, chief economist at European investment bank Saxo Bank, said the G20 nations were likely for now to leave it up to their central banks, which can act relatively flexibly and quickly, to handle market turmoil.

But if the economic climate keeps worsening, perhaps with another 10 percent fall by global stocks, G20 governments may be pushed into making a concerted pledge of action to protect markets and growth, as they did at a London summit in April 2009, he said.

G20

By displaying solidarity among world leaders and promising $1.1 trillion for global lending institutions and trade financing, the London summit succeeded in reassuring investors enough to support a recovery in markets and economic growth.

Now, however, it may be harder for governments to show such solidarity. President Barack Obama has been weakened politically, and his economic policy options narrowed, by his battle to push up the U.S. debt ceiling.

Some big countries are further along in their election cycles, complicating decisions. Important elections are due in the United States, Germany and France over the next couple of years, as well as a leadership change in China.

"The maneuverability of governments is much less than it was in the last crisis. A lot of people want to be seen not to be caving in to pressure," Jakobsen said.

During the 2008-2009 crisis, the International Monetary Fund played a major role in coordinating the global response, but there are now signs of internal division, with powerful emerging economies criticizing the policies of Western governments.

Last month, Brazilian and Indian directors of the IMF warned the Fund's management against pouring more large sums of aid into the euro zone debt crisis, while official Chinese media have denounced U.S. politicians as globally irresponsible over the debt ceiling dispute.

These tensions may complicate G20 agreements on action in several areas:

- Joint currency intervention. This is the most likely initial form of G20 cooperation because well-tried mechanisms for it already exist; central banks could send a message that they want stability in markets by intervening massively to stop appreciation of the Swiss franc or Japanese yen.

But China and the rest of the world are still far from agreeing on a more fundamental problem in the global currency system -- the value of the Chinese yuan.

- Coordinated interest rate cuts. In October 2008, six Western central banks cut interest rates in a coordinated move, while China also eased policy.

Global central bankers may signal an easier policy bias when they meet in Jackson Hole in the United States on August 25-27. But coordinated rate cuts look unlikely in the foreseeable future because some central banks such as the U.S. Federal Reserve have very little room left to cut, and central banks are also at different stages in their monetary cycles. The European Central Bank began tightening this year, criticizing Fed policy as too loose; China may still be in tightening mode.

A weakening economy might eventually push the Fed and the Bank of England into printing more money through "quantitative easing." But this would almost certainly not be part of any coordinated G20 move; China and other emerging economies sharply criticized U.S. quantitative easing last year as destabilizing for markets.

- Expansionary fiscal policy. During the 2008-2009 crisis, the G20 did not resolve differences over fiscal policy; Germany resisted U.S. pressure to boost government spending more. But the London summit in 2009 still produced a pledge of "an unprecedented and concerted fiscal expansion" by G20 states, which cheered markets.

Such a pledge is extremely unlikely now, with the euro zone and the United States desperate to reassure investors that they can bring sovereign debt down to manageable levels.

Markets are hoping fiscally strong G20 members may spend more to help weak ones. Germany could change tack and support a major expansion of the euro zone's 440 billion euro bailout fund in order to provide a precautionary credit line to Italy. [ID:nLDE77017G] China might invest more of its $3.2 trillion foreign exchange reserves in euro zone sovereign debt.

Both these measures might be discussed by the G20 and could have a quick, dramatic effect on markets. But they would face some political opposition within the contributing governments, and would not necessarily change the long-term outlook for economies.

(Writing by Andrew Torchia)

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Turkey's Gul says no crisis as top generals quit (Reuters)

ISTANBUL (Reuters) – President Abdullah Gul denied on Saturday that Turkey faced a crisis after the resignation of the country's four most senior military commanders, but acknowledged this had created an "extraordinary" situation.

The departure of the generals has caused turmoil in the military, giving Prime Minister Tayyip Erdogan an opportunity to extend his authority over the once-dominant armed forces, the second biggest in NATO.

Chief of General Staff General Isik Kosaner stepped down on Friday evening along with the army, navy and air force commanders in protest over the detention of 250 officers on charges of conspiring against Erdogan's government.

In a farewell message to "brothers in arms," Kosaner said it was impossible to continue in his job as he could not defend the rights of men who had been detained as a consequence of a flawed judicial process.

Relations between the secularist military and Erdogan's socially conservative Justice and Development Party (AK) have been fraught since it first won power in 2002, due to mistrust of the AK's Islamist roots.

While the departures are embarrassing, they could give Erdogan a decisive victory over a military that sees itself as guardian of the secularist state envisioned by the soldier statesman and founder of modern Turkey, Mustafa Kemal Ataturk.

Analysts perceive little political threat to Erdogan's supremacy. AK won a third consecutive term, taking 50 percent of the vote, in a parliamentary election in June.

"Nobody should view this as any sort of crisis or continuing problem in Turkey," Gul, a former top AK member, told reporters on Saturday. "Undoubtedly events yesterday were an extraordinary situation in themselves, but everything is on course."

Erdogan designated Kosaner's successor on Friday, as his office put out a statement naming paramilitary Gendarmerie commander General Necdet Ozel as new head of land forces and acting deputy chief of general staff, effectively making him next in line when Kosaner handed over the baton.

In years gone by, Turkey's generals were more likely to seize power than quit. They have staged three coups since 1960 and pushed an Islamist-led government from power in 1997.

Some founders of AK, including Erdogan, were members of the Welfare Party, an Islamist party whose coalition was forced out 14 years ago. But as prime minister, Erdogan has ended the military's dominance through a series of reforms aimed at advancing Turkey's chances of joining the European Union.

FOUR-STAR EARTHQUAKE

"Four-star earthquake," a headline in Sabah newspaper said of the generals' decision, while papers also highlighted Kosaner's criticism of media reporting on the military.

"They tried to create the impression that the Turkish Armed Forces were a criminal organization and ... the biased media encouraged this with all kinds of false stories, smears and allegations," Kosaner's statement said.

On Istanbul's streets, views of the issue reflected Turkey's polarization between government supporters and opponents.

"This is a move to place AK Party supporters in the army. There was only the army to protect secularism but they took that as well," said retired 54-year-old Perihan Guclu.

"This has been a good development. We have got one of the biggest numbers of generals in the world but we are becoming a democracy slowly," said a 52-year-old who gave his name only as

Dursun.

The latter-day subordination of the generals was starkly demonstrated last year when police began detaining scores of officers over "Operation Sledgehammer," an alleged plot against Erdogan's government discussed at a military seminar in 2003.

The officers say Sledgehammer was just a war game exercise and the evidence against them has been fabricated. About 250 military personnel are in jail, including 173 serving and 77 retired staff. Most are charged in relation to Sledgehammer.

MILITARY MORALE SAPPED

A court accepted on Friday an indictment over another alleged military plot, known as the "Internet Memorandum" case, and prosecutors asked for the arrest of 22 people including the Aegean army commander and six other serving generals and admirals.

Aksam newspaper described this as "the indictment which triggered a crisis" in a case where the military is accused of setting up anti-government websites. Papers said disagreements over senior appointments also prompted the generals to quit.

The detentions have sapped morale and spread mistrust and suspicion among the officer corps, and many had been looking for Kosaner to take a stand since his appointment last August.

More than 40 serving generals, almost a tenth of Turkey's commanders, are under arrest, accused of a various plots to bring down the AKP.

The main opposition CHP said the army should stay out of politics but warned against the AKP exploiting its power.

"It is not right to draw soldiers into politics but there is no benefit in vilifying, smearing or undermining their dignity day and night," senior CHP deputy Emine Tarhan told a news conference.

The government statement said the four commanders had retired and made no mention of the reasons why. It said a meeting of the Supreme Military Council, which meets twice-yearly to make top appointments, would go ahead as planned on Monday, showing Erdogan is in a hurry to restore the chain of command and present an image of business as usual.

The announcement dampened sentiment on Turkey's financial markets on Friday, weakening the lira and pushing bond yields higher over concerns about increased political risk.

(Additional reporting by Daren Butler and Seda Sezer; Editing by Mark Heinrich)

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Pawlenty: Obama not showing courage in debt crisis (AP)

WASHINGTON – GOP presidential candidate Tim Pawlenty says President Barack Obama is showing no courage in the debt showdown. "If you're the leader of the free world, would you please come to microphone and quit hiding in the basement about your proposals, and come on up and address the American people? Is he chicken?" the former Minnesota governor told CNN's "State of the Union."

He said Obama needs to talk specifically and publicly about where he would cut entitlement programs to reduce the nation's debt. Obama has been negotiating with congressional leaders in an attempt to raise the government's borrowing limit ahead of an Aug. 2 deadline to avoid a financial default.

"Where's the president of the United States on the most pressing financial challenges of our country on entitlement reform? Where is his specific Medicaid reform proposal? Where is his specific Medicare reform proposal? Where is his Social Security reform proposal?" Pawlenty asked.

"The answer is he doesn't have one. You can't find him publicly talking about that. He's ducking, he's bobbing, he's weaving. He's not leading, and that's not the kind of president we need, and that's why he needs to be removed from office.

Pawlenty himself has criticized for not being aggressive enough in his 2012 campaign.

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Europe nears agreement on Greek crisis bailout (AP)

BRUSSELS – Greece would get some relief on part its massive debts and a Europe-wide rescue fund would gain new powers to swiftly aid other debt-stricken countries under a sweeping deal being negotiated by eurozone leaders Thursday.

Though the deal would likely trigger a temporary default by Greece — the first ever by a euro state — it could also help the ailing country emerge from its debt hole in the longer term and shake up Europe's way of handling the crisis, by making it more proactive.

Stocks, bonds and the euro rallied sharply on hopes that the deal will be a turning point in the eurozone's 18-month debt crisis. Growing market panic has weighed on the single currency and forced already bailed out Greece, Portugal and Ireland as well as struggling Spain and Italy to make billions of euros in cuts.

A draft of the deal seen by The Associated Press said that banks and other private investors that own Greek bonds have agreed to contribute to the rescue of the country — language indicating that they will accept being paid back more slowly or at lower interest rates.

This could happen through banks trading their current bonds to Greece for new ones that mature years later. The banks could also sell their bonds back to Greece at a loss.

Ratings agencies have long warned that such measures would be seen as a form of Greek default on its loans, a first for a eurozone country and a potential cause of devastating loss of confidence in the other heavily indebted nations.

Markets appeared to be seeing the draft measures as less harmful than expected, however, fueling the rally.

"Greece is in a uniquely grave situation. This is the reason why it requires an exceptional solution," the draft says.

The draft deal, if approved, would also radically overhaul a bailout fund created last year after Greece was bailed out with euro110 billion ($156 billion) in rescue loans by the other eurozone countries and the International Monetary Fund. Like Greece, Ireland and Portugal have since found themselves increasingly unable to sell bonds with sharply higher rates demanded by investors frightened that their struggling economies would leave them unable to repay their debts.

But so far the European Financial Stability Facility could only be tapped once a country was on the brink of financial collapse and after it agreed to huge cuts and changes to the way its economy is run.

The deal would now allow the EFSF to intervene pre-emptively, before a country is in full-blown crisis mode.

For instance, countries could be given a "precautionary program," likely some form of credit line. That might allow states under stress, like Spain, to continue raising money on the markets, giving an extra assurance to investors, and could also make it easier for Ireland and Portugal to re-enter the markets once their bailout programs expire.

Money from the EFSF could also be used in some situations to recapitalize banks in countries that have not yet been bailed out, the draft says.

On top of that, the draft says, the EFSF could be authorized to buy up bonds of troubled countries on the open market, maintaining the prices of the bonds and keeping their interest rates from skyrocketing in the face of pressure from worried investors.

A eurozone official told The Associated Press that the draft was "definitely not final" and that "anything can change," speaking on condition of anonymity because of the sensitivity of the negotiations.

Even though initial market reaction to the draft deal was positive, the euro traded up 0.8 percent at $1.4371 after it had slumped earlier in the day, analysts warned that it won't constitute a turning point in the eurozone's debt travails.

"From what we can see, there are still couple of major shortcomings," Jonathan Loynes, chief European economist at Capital Economics in London, said in a note. The deal would reduce Greece's near-term financing needs, but won't significantly lower the overall debt burden, Loynes said, adding that "there is no 'shock and awe'," that would boost market confidence in the eurozone as a whole.

A major fear about a potential Greek bond default has been the potential for massive disruption to the Greek banking system. Greek banks use Greek government bonds that they own as collateral for short-term loans they receive from the European Central Bank.

That money funds the banks' day-to-day operations, including short-term loans to private businesses.

A default would render the bonds useless as collateral, causing that funding to dry up and wreaking havoc on the Greek economy.

To prevent that, the eurozone could provide some form of repayment guarantee or collateral for the new Greek bonds banks would take on, the draft says.

According to the draft, the eurozone and the International Monetary Fund are also ready to give new rescue loans to Greece, without providing a number.

Eurozone leaders also plan to ease the loan conditions for their part of the bailout, by doubling the average loan maturity for Greece to at least 15 years from 7 1/2 years currently and reduce the interest rate to 3.5 percent.

Those softer loan conditions would also apply to Ireland and Portugal.

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Summers urges aggressive euro zone crisis response (Reuters)

WASHINGTON (Reuters) – Former White House aide Lawrence Summers on Sunday urged Europe to take a more aggressive response to the debt crisis sweeping the region and suggested patience with its approach was running thin.

In an opinion piece published by Reuters, Summers -- a Harvard professor and former Treasury secretary under President Bill Clinton -- said that if Europe does not get the crisis under control soon, other G20 countries should become more vocal in pressing Europe on doing what they think is best.

"It is to be hoped that European officials can engineer a decisive change in direction but if not, the world can no longer afford the deference that the IMF and non-European G20 officials have shown toward European policy makers over the last 15 months," Summers wrote.

His comments came ahead of a summit of Euro zone leaders Thursday in Brussels aimed at a second rescue deal for Greece.

Alarmed by the spread of market jitters over Greece to Italy and Spain, where bond yields have surged in the past 10 days, European governments are struggling to put together a second bailout of Greece that would supplement a 110 billion euro rescue launched in May last year.

Summers argued that if there is any chance for success in stemming the financial crisis, policymakers must first recognize that maintaining systemic confidence is key.

"There must be a clear and unambiguous commitment that whatever else happens, the failure of major financial institutions in any country will not be permitted," Summers wrote.

He said the European Central Bank (ECB) was right to be concerned that punishing creditors for the sake of teaching lessons or building political support was reckless in a system that depends on confidence.

Summers, who headed the National Economic Council for the first two years of the Obama administration, called for a fundamental shift toward an approach that focuses on avoiding systemic risk.

He also laid out measures for containing the euro-debt storm including:

* Interest rates on official sector debt be reduced to a European borrowing rate defined as the rate at which common European entities backed with joint and several liability by all the countries of Europe can borrow.

* Countries whose borrowing rate exceeds some threshold -- perhaps 200 basis points over the lowest national borrowing rate in the Euro system -- should be exempted from contribution requirements for bailout funds.

* Countries judged to be pursuing sound policies will be permitted to buy EU guarantees on new debt issuances at a reasonable price payable on a deferred basis.

"The alternative to forthright action today is much more expensive action -- to much less benefit -- in the not too distant future," Summers wrote.

"The next few weeks may well be among the most consequential in the history of the European Union."

(Reporting by JoAnne Allen; editing by Todd Eastham)

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Clinton backs Greek strategy on debt crisis (Reuters)

ATHENS (Reuters) – Secretary of State Hillary Clinton on Sunday voiced strong U.S. support for Greece's battle to overcome its debt crisis, saying it was taking the difficult steps required for future growth.

Clinton's visit to Athens was intended to signal Washington's backing for Prime Minister George Papandreou ahead of a meeting of euro zone leaders in Brussels on Thursday to decide on a new bailout package for Greece amid fears the debt crisis could spill over to Spain and Italy.

"Americans know these are difficult days, and again we stand with you as friends and allies," Clinton said at a news conference.

"The United States strongly supports the Papandreou government's determination to make the necessary reforms to put Greece back on a sound financial footing and to make Greece more competitive economically."

While Washington believes European countries should take the lead in managing the Greek debt crisis, it has also been pushing through its membership in the International Monetary Fund (IMF) to support Papandreou's austerity plans, which have led to violent protests at home.

Clinton said Greek's politically painful plan for a medium-term fiscal strategy and bringing down its whopping debt were like "chemotherapy," but would bring results in the end.

"I am not here to in any way downplay the immediate challenges because they are real. But I am here to say that we believe strongly that this will give Greece a very strong economy going forward," Clinton said.

Greek Foreign Minister Stavros Lambrinidis said that despite the popular outrage over the deficit reduction plan, the government was determined to forge ahead.

"We believe that we shall come out of this difficulty victorious," he said. "Many on both sides of the Atlantic have bet on the collapse of Greece and then have been proven wrong. We will continue to prove them wrong."

DIGGING OUT

Greece, which has launched an austerity plan, is hoping for a second European bailout package of about 110 billion euros of extra funds to keep it financed until the end of 2014, when it is supposed to return to financial markets.

Clinton was due to meet Papandreou, President Karolos Papoulias and Finance Minister Evangelos Venizelos before heading to the Acropolis museum in central Athens to sign a cultural agreement designed to prevent trafficking of Greece's rich trove of cultural artifacts.

Despite financial headaches on both sides of the Atlantic, U.S. officials say ties between Washington and Athens are strong and that Greece has been a valuable partner in NATO-led campaigns in both Afghanistan and Libya.

The United States was also grateful to Athens for taking steps to prevent a planned activist flotilla from sailing for Gaza earlier in July, heading off what Washington feared could have been a dangerous confrontation between the pro-Palestinian activists with Israel, which had vowed to block the ships.

U.S. officials said Clinton also discussed several of Greece's diplomatic priorities including remaining strains in its relationship with Turkey and slow reunification talks on the ethnically-split island of Cyprus.

Clinton, who arrived in Greece on Saturday after a visit to Turkey which included a meeting of the international contact group on Libya, is due to depart on Monday for a visit to India that will begin the Asian segment of her round-the-world trip.

(reporting by Andrew Quinn, editing by Peter Millership)

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Euro zone makes fresh bid to tackle Greek crisis (Reuters)

BRUSSELS/BERLIN (Reuters) – Euro zone countries continued to grapple with the thorny issue of involving the private sector in tackling Greece's debt pile as they prepared for a meeting to decide support for the country next week.

"The principle of having a euro chiefs' meeting is accepted by the main players, including Germany," said one EU diplomat, adding that it was likely to happen next week despite earlier signals from Berlin that there was no rush to finalize a second package of aid.

First, however, countries have to agree how to involve private sector investors in tackling Greece's debt burden, a key demand of Germany before it signs off more support for Athens and a step the International Monetary Fund said on Wednesday must be taken.

"Comprehensive private sector involvement is appropriate, given the scale of financing needs and the desirability of burden sharing," the IMF said in its latest review of the debt-choked country.

"Greece's debt service capacity may also need to be bolstered by combining appropriate PSI and official support," IMF officials wrote, referring to private-sector involvement.

Ratings agency Fitch cited continued uncertainty about private-sector participation and foot-dragging on giving more aid to Greece, when it downgraded the country further into junk territory.

Euro zone leaders' agreement to meet followed warnings they needed to act quickly after markets were rattled by the failure of finance ministers to reach agreement earlier this week.

Italian central bank chief Mario Draghi, soon to take the helm of the European Central Bank, and Ireland's premier both said a definitive plan was needed and quickly -- echoing a strongly-worded attack from Greece's prime minister earlier in the week.

The spotlight was taken off the euro zone, at least temporarily, after the Federal Reserve Chairman Ben Bernanke said the central bank could resort to more monetary stimulus if a sluggish U.S. economy weakens further.

Ratings agency Fitch had also countered the bleak outlook in Europe following an earlier downgrade of Ireland to junk status by Moody's when it said Italy could keep its credit status by sticking to fiscal targets.

But many remained on edge after a market attack on Italy and concerns that it too could need assistance, something that would overwhelm the euro zone's existing rescue funds.

"Moody's problem is not with Ireland, Ireland's problem is with Europe," Prime Minister Enda Kenny told parliament, as the cost of insuring Irish debt climbed.

"There is no point in having a meeting that won't bring about a conclusion in a comprehensive sense to something that is not going to go away unless it is dealt with."

WRANGLING

Should the leaders meet, they will need to pin down how private owners of Greek government bonds can be persuaded to shoulder a portion of the cost of a new package for Greece, a key demand of Germany.

They will weigh up the potential impact on markets if securing such involvement is declared a debt default by ratings agencies, as expected.

But countries had appeared to be subsiding into a bout of internal wrangling and risk creating a no-win situation.

"Markets reacted very badly after euro zone finance ministers could not reach an agreement," an EU diplomat said, referring to a finance ministers' meeting on Monday. "If they cannot agree, we take the fight to the highest level."

Herman Van Rompuy, the presides over meetings of EU leaders, had originally informed ambassadors he wanted to hold a summit on Friday evening.

But Europe's biggest economic power, Germany, which one EU official said was angry about being "backed into a corner", was reluctant, pushing the date of the gathering into next week.

STRESS TESTS

Another concern of leaders are the results of stress tests of European banks.

That could have a further impact on Italy, where bank stocks and the bond market have been hit by growing concerns that the euro zone's third-largest economy could be next in line after Greece, Ireland and Portugal to suffer debt contagion.

Draghi said Italian banks would comfortably pass the tests but echoed Kenny's call for a comprehensive EU response to the spreading debt crisis.

"We have to recognize that management of the financial crisis has not gone smoothly with partial and temporary interventions," he said in a speech.

"We must now bring certainty to the process by which sovereign debt crises are managed, by clearly defining political objectives, the design of instruments and the amount of resources," he said.

There are two main proposals on the table for securing the private sector's involvement in reducing Greece's debt burden.

One would be to buy back Greek bonds at a discount. Another is to swap Greek debt for longer-dated securities with a lower coupon.

However, it remains unclear how a buy-back of Greek bonds would be financed. It could involve using the 440 billion euro European Financial Stability Facility (EFSF).

The ECB remains vehemently opposed to any Greek plan that ratings agencies would be likely to see as a default.

ECB policymaker Jens Weidmann said the EFSF should not be used to buy bonds in the secondary market and it would be unacceptable for the ECB to accept Greek debt as collateral if the country were in default.

"The money of the (EFSF) bailout should not be used for the purchase of government bonds in the secondary market," he told Die Zeit newspaper. "Containment of the crisis should not mean that we undermine our principles. We must draw a red line."

But Germany's finance ministry said funds from the euro zone's rescue mechanism could in theory be used by members of the bloc to buy back their own bonds, suggesting a shift in Berlin's stance.

(Additional reporting by Julien Toyer and Luke Baker in Brussels, and by Noah Barkin and Gernot Heller in Berlin; editing/writing by Mike Peacock)

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Debt crisis spreads to shake Europe's core (AP)

BRUSSELS – The debt crisis shook Europe's core on Tuesday as market fears grew over the stability of Spain and Italy, forcing a rethink of the currency union's strategy to restore trust in its future.

Markets took a nosedive on worries that the eurozone's third and fourth biggest economies — both too expensive to save with Europe's rescue funds — may become the crisis' next victims.

On the one hand, investors are concerned by the EU's determination to get banks to share the burden of bailouts, even at the cost of triggering a Greek default. On the other, they see in EU disagreements over giving Greece more aid the ominous signs of a drop in commitment to the currency union.

The mix of uncertainty proved toxic for markets. The sell-off extended to Italy, one of Europe's stable core economies, which despite its high debt had so far escaped the turmoil that has crippled the eurozone for a year and a half.

The contagion "could mark the beginning of the end for the single currency union in its current form," Jonathan Loynes, economist at Capital Economics.

As so often before, the eurozone finance ministers were pushed into action only when the markets gave them no choice.

Italy's government sped up approval of its austerity plan and the EU opened the door for a complete overhaul of the region's bailout fund, which has so far focused on handing out rescue loans to countries on the brink of collapse in return for high interest rates and painful austerity measures.

The pledges calmed market nerves — for the day, at least. The euro bounced back above $1.40 from as low as $1.3885 in the morning and Milan's stock index swung to a 1.2 percent gain after being down as much as 4.4 percent.

"We said we are ready to test, whether, as part of the private sector involvement, an expansion of the toolkit is necessary and appropriate — such as prolonging (loan) maturities and lowering interest rates," said German Finance Minister Wolfgang Schaeuble. "Everything can help to improve debt sustainability and defend the euro as a whole."

Schaeuble did not exclude new powers for the eurozone's rescue funds, such as buying up the bonds of troubled countries on the open market, which could lower the debt weight and help stem market jitters, especially for a country like Greece, which few economists believe can stand on its own feet again without substantial additional support.

Until very recently, Germany, the eurozone's largest economy and the biggest contributor to the region's bailout fund, had firmly ruled out such expanded powers.

Schaeuble indicated that the heightened market panic may have led to a change in opinion. "We never before had such an intensive and honest debate over the real issues," he told journalists at the end of a two-day meeting with his counterparts in Brussels.

But while the promises of more support stabilized European markets by the close of the day on Tuesday, sentiment remains fragile as the eurozone's top officials — once again — remained thin on details and appeared to disagree among themselves.

Calm will return to markets only if "all the countries of the eurozone assume their responsibility, in particular the most powerful countries," Spanish Prime Minister Jose Luis Rodriguez Zapatero told reporters in Madrid.

The comment seemed to be a direct rebuke to German Chancellor Angela Merkel, whose reluctance to anger taxpayers at home has blocked previous efforts to get ahead of the debt crisis.

Because of the heightened tensions, this week could become crucial to the eurozone's ability to survive the crisis. EU President Herman Van Rompuy said there may be a special summit of EU leaders in Brussels Friday, the same day as the results of long anticipated bank stress test will be revealed.

While the finance ministers struggled in Brussels, Italy worked to restore confidence in its ability to tackle its debt pile, some 120 percent of economic output and one of the biggest in the eurozone.

Italian Premier Silvio Berlusconi said the government will bring forward the timetable it has for a raft of austerity measures, which are now meant to pass through parliament by Sunday, instead of waiting until August.

Berlusconi said in a statement that the turmoil in Italian financial markets in recent days has prompted the government to accelerate and strengthen the measures, so that the country can have a balanced budget by 2014.

"It is necessary to eliminate every doubt on the efficiency and credibility of the austerity measures," Berlusconi said in his first public comments since speculators started pushing up the interest rates Italy pays on its debt.

Berlusconi, who has been weakened in recent local elections and referendums on his policies as well as a sex scandal, expressed confidence that the government and opposition would work together "to defend the country."

The comments helped the Italian 10-year yield drop back down to 5.55 percent from above 6.0 percent earlier, while the Milan stock index turned positive to trade 1.2 percent higher — its first rise in days.

____

Barry reported from Milan. David McHugh in Brussels, Maria Grazia Murru in Rome and Daniel Woolls in Madrid contributed to this story.

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Italy's Berlusconi seeks to calm fears over crisis (Reuters)

ROME (Reuters) – Prime Minister Silvio Berlusconi sought on Tuesday to calm fears that Italy could be swept into a full-scale financial crisis as the center-left opposition pledged to help parliamentary approval of debt-cutting measures.

"For us, for Italy, this is certainly not an easy moment," Berlusconi said in a statement that followed a chaotic morning on financial markets in which Italian 10-year bond yields climbed past 6 percent, their highest level in over a decade.

Economy Minister Giulio Tremonti left a meeting of euro zone finance ministers early to return to Rome to wrap up approval of a 40 billion euro ($56 billion) package of austerity measures expected to be passed in parliament in the coming days.

"The actions under discussion in parliament will accelerate the reduction of the debt. Already this year, we will bring the primary balance into significant surplus," Berlusconi's statement said.

"The crisis is pushing us to accelerate the process of correction extremely rapidly, to strengthen its content, to fully define further steps to bring the budget into balance by 2014."

Opposition parties said that despite objections to parts of the package, which cuts funding to local government and health services and delays retirement, they would support parliamentary approval of the bill by Friday so that it would be passed by the time markets open on Monday.

With Italy sitting on 1.6 trillion euros of outstanding government bonds, any increase in borrowing costs could severely disrupt efforts to cut a debt mountain equivalent to 120 percent of gross domestic product.

Earlier, the premium investors demand to hold Italian debt rather than benchmark German bonds widened to a record 350 basis points. Bank shares also dropped heavily before markets picked up following Tremonti's return home.

"SACRIFICES"

"Any delivery from the government on the austerity package, any good news in that respect, is very, very positive. So if politicians are getting their act together, it's absolutely good news," said Royal Bank of Scotland analyst Paola Biraschi.

As the morning panic on the markets eased, the 10-year Italian/Bund spread dropped back to 288 points, 15 basis points tighter on the day, after an auction of short-term bills (BOTs) passed off without any serious problems.

Italy, the euro zone's third largest economy, has largely avoided the turmoil hitting Greece, Portugal and Ireland, thanks to a relatively modest budget deficit, a conservative banking system and a high level of private savings.

But it has been targeted over worries about the sustainability of its mountainous public debt burden, raising the threat of a crisis which could potentially overwhelm the euro area and break up the single currency.

Tremonti has overseen a four-year, 40 billion-euro austerity package designed to keep the government on track to meet a target of cutting the public deficit from 3.9 percent of GDP in 2011 to bring it into balance by 2014.

With the opposition ready to support the package, a number of smaller amendments were discussed late on Tuesday, including easing rules on amortization of infrastructure assets held by private concessionaires and changes to tax and pension measures.

The changes would see planned tax hikes on holders of financial instruments eased for small investors, while rules on inflation adjustment for pensions would be weighted against higher incomes and in favor of lower and middle incomes.

The government was also working on a measure that would ensure that 15 billion euros of fiscal measures penciled into its austerity plan were cemented into the final package.

Tremonti has faced reluctance and even outright resistance from some in the government worried about the electoral impact of unrelenting austerity but this week's crisis appears to have overcome such resistance.

In a gravely worded statement, Berlusconi, who normally exudes optimism and who has hitherto boasted of his government's success in keeping out of the crisis, said Italy had overcome even more difficult moments in its past.

"We must be united, cohesive in our common interest, conscious that the efforts and sacrifices of a brief period will correspond to permanent and secure gains," he said.

Markets plunged on Friday after a newspaper interview in which Berlusconi criticized the sometimes abrasive Tremonti for not being a "team player," a remark which underlined persistent tensions in the government.

(Additional reporting by Francesco Guarascio in Brussels, Ian Simpson in Milan, Giuseppe Fonte in Rome; Editing by Alison Williams)

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UN: Somalia drought is worst humanitarian crisis (AP)

By MALKHADIR M. MUHUMED and LUC VAN KEMENADE, Associated Press Malkhadir M. Muhumed And Luc Van Kemenade, Associated Press – 1?hr?6?mins?ago

DADAAB, Kenya – The head of the U.N. refugee agency said Sunday that drought-ridden Somalia is the "worst humanitarian disaster" in the world after meeting with refugees who endured unspeakable hardship to reach the world's largest refugee camp.

The Kenyan camp, Dadaab, is overflowing with tens of thousands of newly arrived refugees forced into the camp by the parched landscape in the region where Somalia, Ethiopia and Kenya meet. The World Food Program estimates that 10 million people already need humanitarian aid. The U.N. Children's Fund estimates that more than 2 million children are malnourished and in need of lifesaving action.

Antonio Guterres, the head of UNHCR who visited Dadaab on Sunday, appealed to the world to supply the "massive support" needed by thousands of refugees showing up at this camp every week. More than 380,000 refugees now live there.

In Dadaab, Guterres spoke with a Somalia mother who lost three of her children during a 35-day walk to reach the camp. Guterres said Dadaab holds "the poorest of the poor and the most vulnerable of the vulnerable."

"I became a bit insane after I lost them," said the mother, Muslima Aden. "I lost them in different times on my way."

Guterres is on a tour of the region to highlight the dire need. On Thursday he was in the Ethiopian camp of Dollo Ado, a camp that is also overflowing.

"The mortality rates we are witnessing are three times the level of emergency ceilings," he said. "The level of malnutrition of the children coming in is 50 percent. That is enough to explain why a very high level of mortality is inevitable," he said.

Dr. Dejene Kebede, a health officer for UNHCR, said there were 58 deaths in camps in one week alone in June.

Most of the deaths take place at the registration office and transition facilities of the refugee camps in the southeastern Dollo region of Ethiopia, the health officer said.

Up to 2,000 Somali refugees are crossing the border into Ethiopia every day, UNHCR said. Thousands of families arrive in poor conditions often after walking for days in search of food.

Guterres said the influx is overwhelming for UNHCR and other international and local aid organizations: "Nothing can compare to what we have seen this month."

"I believe Somalia represents the worst humanitarian disaster in the world," he said.

The camps are full and lack capacity to provide the Somali people with food and shelter.

This makes effective health treatment almost impossible, said Jerome Souquet, head of Doctors Without Borders at the Dollo Ado camps.

"We can treat the severely malnourished children, but they will definitely come back to us underfed because there is not enough food and almost all of them suffer from diarrhea," he told The Associated Press.

Habiba Osman Ibrahim, a 76-year old Somali refugee from the al-Shabab-controlled Luk region of Somalia, said she walked for three days with her two underfed grandchildren. Al-Shabab is Somalia's dangerous militant group. It had forced out all international aid groups, but earlier this month said they could return considering the desperate conditions.

"We were dependent on food aid," she said. "But because al-Shabab forced out all relief operations and there was no food we had no choice but to flee."

Aden Dayow, 32, said he was a sorghum-growing farmer in Ufurow in Somalia, but fled to Ethiopia because his harvest failed because of a lack of rains.

The epicenter of the drought lies on the three-way border shared by Kenya, Ethiopia and Somalia, a nomadic region where families heavily depend on the health of their livestock. Uganda and Djibouti have also been hit.

The World Food Program said it expects 10 million people in the Horn of Africa to require food assistance. WFP currently provides food aid to 6 million people in East Africa.

The group said it is facing a shortfall of 40 percent on the $477 million needed to address hunger needs in the region.

Somalis desperate for food are also overrunning Dadaab, the world's largest refugee camp in neighboring Kenya, which is seeing some 10,000 new arrivals each week, six times the average at this time last year.

The U.N.'s refugee agency says Dadaab's three camps now host more than 382,000 people, while thousands more are waiting at reception centers outside the camp.

___

Van Kemenade contributed to this report from Dollo Ado and Bisle, Ethiopia.

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Exclusive: EU calls emergency meeting as crisis stalks Italy (Reuters)

BRUSSELS (Reuters) – European Council President Herman Van Rompuy has called an emergency meeting of top officials dealing with the euro zone debt crisis for Monday morning, reflecting concern that the crisis could spread to Italy, the region's third largest economy.

European Central Bank President Jean-Claude Trichet will attend the meeting along with Jean-Claude Juncker, chairman of the region's finance ministers, European Commission President Jose Manuel Barroso and Olli Rehn, the economic and monetary affairs commissioner, three official sources told Reuters.

Van Rompuy's spokesman Dirk De Backer said: "It's a coordination, not a crisis meeting." He added that Italy would not be on the agenda and declined to say what would be discussed.

However, two official sources told Reuters that the situation in Italy would be discussed. The talks were organized after a sharp sell-off in Italian assets on Friday, which has increased fears that Italy, with the highest sovereign debt ratio relative to its economy in the euro zone after Greece, could be next to suffer in the crisis. A second international bailout of Greece will also be discussed, the sources said.

The spread of the Italian 10-year government bond yield over benchmark German Bunds hit euro lifetime highs around 2.45 percentage points on Friday, raising the Italian yield to 5.28 percent, close to the 5.5-5.7 percent area which some bankers think could start putting heavy pressure on Italy's finances.

Shares in Italy's biggest bank, Unicredit Spa, fell 7.9 percent on Friday, partly because of worries about the results of stress tests of the health of European banks that will be released on July 15. The leading Italian stock index sank 3.5 percent.

The market pressure is due partly to Italy's high sovereign debt and sluggish economy, but also to concern that Prime Minister Silvio Berlusconi may be trying to undermine and even push out Finance Minister Giulio Tremonti, who has promoted deep spending cuts to control the budget deficit.

"We can't go on for many more days like Friday," a senior ECB official said. "We're very worried about Italy."

Monday's emergency meeting will precede a previously scheduled gathering of the euro zone's 17 finance ministers to discuss how to secure a contribution of private sector investors to the second bailout of Greece, as well as the results of the stress tests of 91 European banks.

GREECE

Greece is already receiving 110 billion euros ($157 billion) of international loans under a rescue scheme launched in May last year but this has failed to change market expectations that it will eventually default on its debt.

Senior euro zone officials worry that progress toward a second Greek bailout, which would also total around 110 billion euros, is not being made quickly enough and that the delay is poisoning investors' confidence in weak economies around the region.

"We need to move on this in the next couple of weeks. It's not a case of waiting until late August or early September as Germany is saying. That's too late and markets will make us pay for it," a top euro zone official told Reuters on Saturday.

German officials insist they too want to put together the second Greek bailout as quickly as possible, but the private sector's contribution is proving to be a major sticking point.

Germany, the Netherlands, Austria and Finland are determined that banks, insurers and other private holders of Greek government bonds should bear some of the costs of helping Athens. But more than two weeks of negotiations with bankers represented by the Institute of International Finance (IIF), a lobby group, have made next to no progress on agreeing a formula acceptable to all sides.

Initially talks focused on a complex French plan for private creditors to roll over up to 30 billion euros of Greek debt, buying new bonds as their existing ones matured. Around half of proceeds from Greek bonds maturing before the end of 2014 would be rolled over into very long-term debt while 20 percent would be put into a "guarantee fund" of AAA-rated securities.

But as that plan has floundered, Berlin has revived a proposal to swap Greek bonds for longer-dated debt that would extend maturities by seven years. Proposals to buy back Greek bonds and retire them have also been floated.

In a buy-back, the euro zone's bailout fund, the European Financial Stability Facility, might buy Greek bonds from the market, or the EFSF might lend Greece money to buy bonds. However, these schemes would require further changes to the EFSF's rules and would therefore have to go through national parliaments, an official source said.

SQUARE ONE

A senior euro zone official told Reuters on Friday that rather than progress being made in the talks with the IIF, as IIF managing director Charles Dallara has said, all sides were close to being "back to square one."

Dallara will attend the meeting of euro zone finance ministers in Brussels on Monday.

Since the euro zone's debt crisis erupted last year, the region's rich governments have aimed to limit it to Greece, Ireland and Portugal, which have signed up to bailouts totaling 273 billion euros -- a sum that is small compared to the financial resources of the zone as a whole.

Spain, commonly seen as the next potential domino in the crisis, has managed to retain its access to market funding through fiscal reforms. But because of the large sizes of the Spain and Italy, pressure on the euro zone would increase dramatically if those countries eventually needed financial assistance.

(Additional reporting by Francesca Landini in Milan and Gernot Heller in Berlin; Editing by Andrew Torchia)

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