Germany and France have reached a consensus on steps to boost economic coordination within the euro zone as part of a comprehensive anti-crisis package that will also see the scope of Europe's bailout fund bolstered.
German officials said on Wednesday that Chancellor Angela Merkel and French President Nicolas Sarkozy would present joint proposals to strengthen policy coordination in the 17-nation bloc at an EU summit in Brussels on Friday.
German Deputy Finance Minister Joerg Asmussen sent the strongest signal yet that Berlin was prepared to give new powers to the euro zone's rescue fund in exchange for fiscal discipline commitments by other euro members.
We have always said that we would do all that is necessary to defend the stability of the euro zone as a whole, Asmussen told a conference in Frankfurt.
That might include revising the scope and efficiency of the EFSF, he said, referring to the 440 billion euro ($609 billion) European Financial Stability Facility.
No final agreement on a new strategy for combating the euro zone's sovereign debt crisis is expected before a March 24-25 summit, but markets are already welcoming signs that European leaders are zeroing in on a deal to stem contagion from Greece and Ireland to vulnerable countries like Portugal and Spain.
The euro has gained 7 percent on the dollar in the past three weeks to trade above $1.38 for the first time since early November. The risk premiums on Spanish and Greek 10-year bonds are at a three-month low.
Even the spreads betwen Irish bonds and German benchmarks
narrowed on Wednesday on relief that a ratings downgrade from Standard & Poor's was not deeper.
Long seen as the motor behind European integration, Germany and France struggled last year to forge consensus on how to tackle the worst crisis in the single currency's 12-year existence, stoking fears the bloc could break apart.
But Merkel and Sarkozy have overcome their differences in recent weeks to forge the rough blueprint of a grand bargain between French demands for closer economic coordination in the euro zone and Germany's push for more fiscal discipline.
Euro zone countries would pledge to enshrine German-style deficit and debt limits in their national legislation, tie their pensions policies to demographic factors and move toward a harmonization of corporate tax and labor policies under a draft seen by Reuters last week.
French government spokesman Francois Baroin said Paris and Berlin were in constant contact on the negotiations but did not mention any joint proposal.
In an apparent nod to Berlin, France announced on Wednesday that it would reform its constitution to include a golden rule on balancing the budget.
This is a reshaping of our constitution which will fix a clear objective of budgetary equilibrium and will see the means of achieving it, Budget Minister Francois Baroin said.
In exchange for other European partners agreeing, Germany appears ready to meet the demands of other euro members that the EFSF be given additional powers.
Set up in May after the shock bailout of Greece, the fund has a headline number of 440 billion euros but for technical reasons can only lend about 250 billion euros.
Germany now seems ready to boost its effective lending capacity to the full 440 billion euros and possibly allow it to lend to vulnerable countries like Greece so that they can repurchase their bonds at a discount.
Euro zone sources in Brussels said governments of the currency bloc were also seriously considering letting the EFSF buy bonds of distressed governments on the primary market, when they are auctioned by the issuing country.
A senior German official told Reuters that Berlin was coming around to the idea of reducing the interest rate the EU is charging Greece for the loans in its 110 billion euro bailout and extending the period over which those loans must be repaid -- although an extension to 30 years is seen as unlikely.
The hope is that these steps would remove market fears that Greece will eventually have to restructure its debt, a risk that has kept Greek 10-year bond yields above 10 percent for months.
GERMANY DENIES ECB SUCCESSION DEAL
Germany is still mulling whether to allow the EFSF to provide short-term credits to troubled euro zone members but has ruled out the idea of the facility itself buying the debt of single currency bloc members on the secondary market.
I don't think there is a definitive position in the government on every question, a senior German official, who requested anonymity, told reporters in Berlin.
As before, the position of the government is to strengthen the rescue fund and that includes the question of its capacity and how it can be used.
German officials said the anti-crisis package to be agreed in March would not include a successor to Jean-Claude Trichet as president of the European Central Bank later this year.
Bundesbank President Axel Weber is seen as the leading candidate to replace the Frenchman, but the German's public criticism of the ECB's bond-buying program soured France and other southern euro states on his candidacy.
(Additional reporting by Andreas Rinke in Berlin, Marc Jones in Frankfurt, Nick Vinocur, Emmanuel Jarry and Daniel Flynn in Paris, Carmel Crimmins in Dublin)
(Writing by Noah Barkin; editing by Paul Taylor)