Pessimistic comments from EU paymaster Germany and new figures exposing deepening stress among Europe's banks dented financial market hopes of a turning point in the euro zone's debt crisis at a summit this week.
President Nicolas Sarkozy and Chancellor Angela Merkel detailed their plan to amend the EU treaty to anchor stricter budget discipline in the euro area in a letter to European Council President Herman Van Rompuy on Wednesday.
Merkel also spoke by telephone with U.S. President Barack Obama, agreeing on the need to find a lasting and credible solution to the crisis, the White House said.
The French finance minister said the leaders of France and Germany would not leave Friday's European Union summit until a powerful deal is reached to restore market trust and prevent the sovereign debt crisis spiraling out of control.
But while Paris voiced determination, a senior German official gave a downbeat assessment of prospects for an agreement in an apparent effort to jolt partners into accepting Berlin's terms and respecting its red lines.
I have to say today, on Wednesday, that I am more pessimistic than last week about reaching an overall deal ... A lot of protagonists still have not understood how serious the situation is, the official told a pre-summit briefing.
My pessimism stems from the overall picture that I see at this point, in which institutions and member states will have to move on many points to make possible the new treaty rules that we are aiming for, he said, speaking on condition of anonymity.
The euro slipped, share prices turned negative and safe-haven German bond futures rose after the official punctured investors' hopes of a crisis solution, although some diplomats played down his comments as pre-summit brinkmanship.
After several days of recovery, Italian and Spanish bond yields rose sharply as money fled the two most endangered euro zone sovereigns for the relative safe haven of the region's strongest sovereign, Germany.
ALARM IN WASHINGTON
U.S. Treasury Secretary Timothy Geithner, whose fourth trip to Europe in as many months speaks of the alarm in Washington at the damage the debt crisis could wreak on the U.S. economy, backed the Franco-German plan to impose mandatory penalties on euro states that exceed deficit targets.
Geithner underlined the European Central Bank's central role in fighting the crisis, speaking again to ECB President Mario Draghi by telephone just a day after they met in Frankfurt.
I have a lot of confidence in what the president of France and the minister are doing, working with Germany to build a stronger Europe, Geithner told reporters after talks with French Finance Minister Francois Baroin.
Neither Nicolas Sarkozy nor Angela Merkel will leave the negotiating table of this summit until there is a powerful deal, Baroin told Canal+ television.
Euro zone sources said the ECB was closely involved in discussing plans for tighter euro zone fiscal and economic integration before the summit, and Draghi would meet Merkel and Sarkozy in Brussels on Thursday evening.
Draghi signaled last week that a euro zone fiscal compact could enable the ECB to act more forcefully. The sources said he wanted a firm commitment set in stone that euro zone countries were moving towards a fiscal union before stepping up crisis-fighting measures.
Euro zone graphics package http://r.reuters.com/hyb65p
Interactive timeline: http://link.reuters.com/rev89r
NO G20 DEAL
In Ottawa, Finance Minister Jim Flaherty repeated Canada's position that European countries had sufficient resources to solve their own problems, and said the International Monetary Fund should concentrate on helping poor nations.
Japan's Nikkei newspaper reported in its online edition that the Group of 20 advanced and emerging economies planned to put together a $600 billion IMF lending facility for the euro zone, with contributions from leading members such as Japan, the United States and China.
But Flaherty said there was no such agreement. There have been discussions for some weeks about IMF resources and the possibility of increasing IMF resources, he told reporters.
There are some nuances to the positions of some countries, but I assure you there has been no commitment by the G20 to any specific resourcing plan, he told reporters.
An IMF spokesman also denied the Fund had been involved in talk on such a lending facility.
Figures released on Wednesday showed just how urgently some European banks need help.
Italian banks had to borrow 153.2 billion euros in emergency liquidity from the ECB in November, up from 111.3 billion euros at the end of October, Bank of Italy data showed, another big leap in reliance on the central bank which has almost quadrupled since June, when Italian lenders took 41.3 billion euros.
Euro zone banks took more than $50 billion in the ECB's first dollar funding operation since the world's leading central banks agreed last week to cut their cost, five times the $10 billion forecast in a Reuters poll of money market traders.
And Germany is set to reactivate a bank rescue fund created at the height of the 2008 financial crisis at next week's cabinet meeting, a government official said.
The ECB's governing council holds a crucial meeting on Thursday, before the EU summit, at which most economists expect it to cut interest rates to 1.0 percent from 1.25 percent, introduce longer-term liquidity tenders for banks and widen the collateral they can use to borrow from it.
Ratings agency Standard & Poor's heightened the sense of crisis this week by warning it could cut credit ratings across the 17-nation currency bloc, including for its EFSF rescue fund, a move that would fundamentally weaken it.
A Reuters poll of 13 economists found 11 expect France to lose its top-notch AAA credit rating within three months, a potential blow to Sarkozy's re-election bid.
NEW IDEAS BUBBLE
Two days before the summit, new ideas bubbled about how to boost the euro zone's crisis capabilities. EU officials said leaders could decide to raise the combined lending limit of the temporary EFSF rescue fund and its successor, the permanent European Stability Mechanism, which France and Germany want introduced a year early, in 2012.
But the German official said he could not foresee running the two funds simultaneously. He also ruled out issuing common euro zone bonds as a longer-term solution or letting the ESM operate as a bank and borrow money from the ECB.
The Franco-German letter to Van Rompuy, who will chair the meeting of 27 EU leaders, went beyond the treaty change proposal announced on Monday.
Merkel and Sarkozy called for a new EU fast track for progress on creating a common corporate tax base, a financial transaction tax and labor market regulations -- ideas that are anathema to EU members such as Britain and Ireland.
A new common legal framework, fully consistent with the internal market, should be established to allowing for faster progress in specific areas, the letter said.
The framework should also cover financial regulation, growth supporting policies and more efficient use of European funds in the euro area, they said.
One key uncertainty hanging over the summit is whether the EU treaty can be changed quickly to strengthen budget control.
Van Rompuy says tighter budget oversight sought by Paris and Berlin for the euro area could be achieved quickly by tweaking a protocol to the EU treaty that would not require full ratification procedures in many countries. The German official dismissed that idea as a trick.
Sarkozy and Merkel want treaty changes to be agreed in March and ratified before the end of 2012. If some countries block treaty change for all 27 EU members, the 17 euro states could proceed with an agreement on their own.
But a senior EU official said: We're not going to save the euro if the result of the summit ends up being a split Europe.
A solution that does not involve all 27 states will be a problem. It will show Europe divided, and the markets are not going to like that.
(Additional reporting by Valentina Za in Milan, Jan Strupczewski in Brussels, Tim Hepher in Geneva, Louise Egan in Ottawa,; Richard Hubbard in London, Alexandria Sage, David Lawder, Jean-Baptiste Vey, Daniel Flynn and Catherine Bremer in Paris, Andreas Rinke and Noah Barkin in Berlin, Tim Castle in London; Writing by Paul Taylor; Editing by David Stamp)