Europe in disarray with France and Germany divided

Leaders admit 'make-or-break' meeting has no chance of success as second summit is convened for next week

Brussels

Eurozone leaders conceded last night that there are still huge divisions on how to solve the bloc's burgeoning debt crisis and that there is no chance of agreement by the end of Sunday's summit, which was originally slated as a make-or-break meeting.

The disarray continued last night when France and Germany announced they would schedule a second summit of EU leaders to take place "by next Wednesday" in order to put in place a deal on the expanded EU bailout fund.

The decision, made apparently without prior consultation with other EU leaders, caused surprise in Brussels. It was also unclear if Sunday's planned meeting would be shelved altogether. Summits should normally be called only by the EU President, Herman van Rompuy, and are held at massive cost, with an army of security personnel and police drafted in. "We were not informed," said one dumbstruck EU diplomat. Another said: "It's about time the French and Germans stopped talking just to each other and starting informing the rest of the world."

The deepening Franco-German row over bailout funding grew on Wednesday after Nicolas Sarkozy made an unscheduled trip to Berlin and admitted afterwards that France and Germany were at odds over how to strengthen the firepower of the recently agreed bailout fund.

Yesterday there was no sign that the Franco-German impasse was anywhere near being broken. German MPs followed Chancellor Merkel in opposing French proposals to turn the European Financial Stability Facility (EFSF) into a bank which could obtain funding directly from the European Central Bank and thereby substantially increase its financial clout.

Wolfgang Schauble, Ms Merkel's veteran Finance Minister, flatly rejected the French proposal yesterday saying "This is not up for discussion." He said Germany would not agree to further EFSF funding beyond levels already agreed by parliament: "There will be no expansion", he said.

Germany's opposition Social Democrats added to the prevailing atmosphere of alarm by demanding that the whole EFSF package should be voted on again by the German parliament if it was altered in any way. Disagreement between Paris and Berlin and growing political turmoil at home caused the Merkel government to threaten to postpone this weekend's Brussels summit.

The chaos caused by Franco-German row was exacerbated yesterday by a new dispute between the European Union and the International Monetary Fund. The IMF was reported to be demanding that approval of the next tranche of financial aid to Greece should be delayed until after the weekend's EU summit.

Brussels officials were quoted as saying that the IMF considered the EU's projections for Greece's debt reduction programme to be "too optimistic" and that it wanted to see if Sunday's meeting clarified the issue.

Greece faces default next month unless it receives its next €8bn tranche of bailout money from the EU and the IMF. Analysts have warned that if Athens is allowed to default on its debt, the larger eurozone economies of Italy and Spain could also be pulled into the financial quagmire causing severe repercussions throughout the global banking system.

Eurozone crisis: The solutions - and who's backing them

The proposals:

Greek creditor 'haircut'

Greece's national debt is now on course to hit 181 per cent of its national output. Economists agree Greece cannot cope with such debt. Even if it was growing strongly it could not meet interest repayments. Policymakers are examining plans to force Greece's creditors – mainly private banks and investors – to accept a writedown in sovereign bond value of more than 50 per cent.

Who's for it Greece is understandably keen. The finance minister, Evangelos Venizelos, was quoted last month as saying that a 50 per cent write-down would be the "best" option for the country. But the Greek government cannot openly call for its debt to be forgiven because international donors would take that as a sign that it is not serious about reforming its economy. The most vocal proponents of a write-down have been German ministers. They are pushing for a maximum write-down to ensure that private banks bear more of the pain of bailing out Greece, rather than the bill being solely picked up by European taxpayers.

Who's against it The opposition to a substantial Greek debt write down has come from French and German banks. Self interest is the reason. Together these two sectors are holding €20bn worth of Greek debt. A significant Greek write down could bankrupt them. The interest of French banks have been championed by the French government, which would have to prop up the French banks if they crumbled. Another powerful opponent of a large Greek write down is the European Central Bank, estimated to be holding €45bn in Greek bonds as a result of its efforts to stabilise eurozone sovereign debt markets last year.

Recapitalise the banks

Some of Europe's largest banks are finding it difficult to borrow as private lenders grow alarmed about their solvency. This is threatening to plunge the European economy into another recession. That is why European leaders are considering plans to require the continent's banks to raise more capital in order to assure investors that they are not about to go bust.

Who's for it Chancellor George Osborne. Britain's banks are considered to be well capitalised compared to those on the continent, and he has been pushing hard for an extensive recapitalisation effort. Germany has accepted that banks need to hold more equity in order calm the markets, but it wants the banks to attempt to tap the private sector before committing government funds for that purpose.

Who's against it German banks are threatening to impose a credit crunch if they are forced to raise their capital levels. They say that, instead of raising new money, they will sell assets. Spanish banks, which would have to raise a large amount, are opposed, too. France has reluctantly accepted its banks need to be recapitalised, but wants the funds to come from the pan-European bailout fund, not state coffers.

Strengthen the EFSF

The €440bn bailout fund, known as the European Financial Stability Facility, is not big enough to offer support to Spain and Italy. That is why policy makers are exploring ways to increase the firepower, or "leverage", of the fund. The goal is to convince investors that, should a larger European member run into trouble raising money, the fund will be able to step in.

Who's for it Britain, whose banks are heavily exposed to Italian and Spanish debt, is pushing for the European Financial Stability Facility to be turned into a "big bazooka" in order to send an unambiguous message to the financial markets. France agrees on the need for decisive action and wants to turn the EFSF into a bank, which would borrow unlimited cash from the European Central Bank, in order to buy up the debt of any distressed European state. The European Commission has been urging European governments down this road too.

Who's against it The European Central Bank has refused to allow itself to be used to leverage the EFSF. Germany supports the ECB's position and has fiercely resisted any attempt to increase the financial commitments of European states to the EFSF. But Berlin has indicated that it might allow the EFSF to be used as a fund to provide insurance for new debt issued by European states. However, there are question marks over whether there are enough resources left in the EFSF for it to be an effective insurer of the €1 trillion of debt that Spain and Italy will need to raise over the two and a half years.

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