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Euro area agrees bond support for Italy, Spain

European finance officials worked on urgent measures on Thursday to bring down the borrowing costs of Spain and Italy, seen as too big to bail out, with EU leaders deeply divided over a solution to the euro zone’s ever widening debt crisis.

French President Francois Hollande said on arrival for his first full European Union summit that he expected agreement on emergency steps to help euro zone partners whose cost of credit had reached unsustainable levels.

“I have come here to get very rapid solutions to support countries in the greatest difficulty on the markets even though they have made considerable efforts to restore their public finances,” Hollande told reporters.

It was the 20^th EU summit since the sovereign debt crisis began in early 2010 after Greece disclosed its public deficit was far higher than previously reported.

Policymakers played down any prospect of a rapid solution to the turmoil which has forced Greece, Ireland, Portugal and now Spain and Cyprus to seek international bailouts.

Reflecting public anxiety about the future of the single currency, European Parliament President Martin Schulz told the summit: “Today, people throughout Europe are casting worried eyes towards Brussels, towards this summit meeting, because they fear that our European project is one step away from disaster.”

Positions were so far apart that even before Thursday’s meeting began EU sources said there was the prospect of another summit in mid-July to try to bridge the differences.

In draft summit conclusions, subject to amendment on Friday, the leaders were set to ask the EU’s top four officials to produce a detailed, time-bound roadmap to a genuine economic and monetary union by December.

But markets may not wait that long.

Italy’s benchmark borrowing costs hit six-month highs at auction on Thursday, piling pressure on Prime Minister Mario Monti to ease squeeze concessions out of Germany.

Rome and Madrid have been pleading for help but had received a cool response from Berlin and other capitals so far. However, senior finance officials were preparing a package of short-term measures that euro zone leaders might adopt on Friday.

Three EU sources said work was focused on using the euro zone’s temporary EFSF rescue fund and a future permanent ESM bailout fund to buy new Spanish and Italian bonds as they were issued to underpin their bond auctions.

The funds will have a maximum firepower of 500 billion euros ($625 billion) once the ESM is fully stocked in 2013, minus 100 billion euros already earmarked to aid Spanish banks.

The package may include dropping the preferred creditor status of ESM loans to Spain, which has spooked investors, if Madrid issues covered bonds backed by state assets or tax revenues, they said.

Italy and Spain would still have to request assistance, which they have been loath to do, and would be subject to fiscal policy conditions and international monitoring. But they might not be required to do more in austerity and structural reforms than they have already undertaken, the sources said.

Another idea under discussion, which EU paymaster Germany has previously opposed, was to allow the rescue fund to lend money directly to recapitalise banks without weighing down troubled governments’ balance sheets, the sources said.

Irish Finance Minister Michael Noonan said the aim was to bring Italy’s 10-year borrowing costs down to around 4 percent, from the 6.19 percent it had to pay on Thursday. But other officials said there was no plan to target a particular rate.

“The Spanish issue is how to recapitalise the banks without it impacting on their overall debt burden,” Noonan said. Ireland, which also suffered a bank meltdown after a property bubble burst, has in interest in seeking similar terms.

“Nein! No! Non!”

Hours later than scheduled, European Council President Herman Van Rompuy announced that agreement has been reached on a package to stimulate economic growth worth 120 billion euros. The delay suggested considerable haggling over even that range of measures, which had been largely pre-agreed.

Merkel is being urged at home to hang tough and reject all efforts to make Germany underwrite European borrowing or banks, which some of her partners say may be the only way to save the single currency.

“Nein! No! Non!” shouted a headline splashed across the front page of the normally sober German business daily Handelsblatt, with a commentary by its editor-in-chief saying Merkel must remain firm at the two-day summit.

Monti is also under mounting domestic pressure to achieve results in reducing Rome’s borrowing costs or risk seeing his technocratic government fall within months as the centre-right and centre-left parties that support him jockey for position before an election due in 2013.

A senior German government source, briefing reporters in Berlin before the summit, played down the leap in Spanish and Italian borrowing costs.

“We would warn against exaggerated panic-making,” he said.

Van Rompuy and European Commission President Jose Manuel Barroso have set long-term goals of creating a euro zone treasury to issue joint bonds in the medium-term, and establishing a banking union with central supervision, a joint deposit guarantee and a resolution fund.

Merkel insists that fundamental reforms to give European Union authorities power to override national budget and economic policies must come before any further shared liability.

Germany has enjoyed an export boom even as the crisis has spread, removing any sense of urgency among voters for radical steps to support other countries.

Turmoil

The euro hit a three-week low and world stocks fell as investors bet that this latest summit would fail to produce concrete measures to tackle the crisis, sending 10-year Spanish government bond yields above the danger level of 7 percent.

Many international investors have deserted Spanish and Italian debt, pushing yields to levels that Madrid at least cannot afford for long as it tries to save banks ravaged by a property market collapse and rein in an overshooting deficit.

France’s Hollande advocates joint “eurobonds”, which would bring down borrowing costs for the weak because the pool of guarantors would include the strongest - principally Germany.

Germany, by contrast, does not want to use its credit rating to support others unless they share control of tax and spending powers first.

Dutch premier Mark Rutte sided with Merkel in arguing against any early move to share liability.

“It’s crucial for us to avoid taking measures that would ease pressure on southern Europe to reform. That is why I seriously question a rapid transition to a banking union, or eurobonds,” he told parliament in The Hague. “That would result in a sort of ‘paracetemol effect’ for southern Europe, like the effect performance enhancers have on athletes.”

Monti has proposed leveraging up the rescue funds to underpin troubled countries’ bonds. But ECB chief economist Peter Praet said he was “very sceptical”.

Finnish Europe Minister Alex Stubb told Reuters that Europe should prepared to live in a state of crisis for the rest of the decade. But he said a stronger and more resilient continent would eventually emerge.

“It is an existential crisis, but it’s probably the best crisis we’ve had. It’s forcing European leaders to take very difficult decisions and as we all know very few difficult decisions have been taken in a relaxed atmosphere,” he said.