A split between the International Monetary Fund and the European Union is threatening to delay Greece's next aid payment in another blow to European efforts to stem the debt crisis.
An admission by French President Nicolas Sarkozy on Wednesday that Berlin and Paris were divided over how to make the euro zone bailout fund more effective had already dented hopes that Sunday's EU summit would bring substantial progress.
News the IMF rated EU projections for Greece's debt too optimistic and wanted to delay approval of the next aid tranche further complicated the picture. The fund wants to wait until after this weekend's summit to see if discussions produce a clearer picture, EU officials said.
Without an 8 billion euro loan payment from the EU and IMF next month Greece faces default, possibly dragging the larger economies of Spain and Italy into the mire and sending shockwaves through the banking system.
Seeking a comprehensive plan, euro zone leaders are racing to agree on new steps to reduce Greece's debt, strengthen the capital of banks with exposure to troubled euro zone sovereigns and leverage the euro zone's rescue fund to stem contagion to bigger economies.
But progress appears to be glacial.
Sarkozy flew to Frankfurt Wednesday evening for emergency talks with German Chancellor Angela Merkel, the head of the IMF and other key euro zone officials. French media reported he missed the birth of his daughter in the process.
France has argued the most effective way of leveraging the European Financial Stability Facility is to turn it into a bank which could then access funding from the ECB, but both the central bank and the German government oppose this.
Failure to reach a deal at Sunday's summit of European leaders would further undermine financial markets' confidence in the currency bloc and its ability to get on top of a two-year-long debt crisis, which threatens the long-term viability of the single currency.
Markets caught up with the downbeat tone from policymakers. The euro fell and European shares were down one percent having risen this week on hopes of comprehensive action from euro zone leaders.
Since France's finance minister pledged a decisive outcome to the Oct. 23 summit last Saturday, expectations have been downplayed with Germany and others saying it will only be another step along the road to solving the debt crisis.
I don't believe that such solutions could be made on Sunday that would ... fix everything. But I'm certain that there will be decisions that point to the right direction, Finnish Prime Minister Jyrki Katainen said in comments broadcast late on Wednesday.
Canada's Finance Minister Jim Flaherty said the two-steps-forward one-step-back approach was disconcerting.
FORCED BANK LOSSES?
Adding to the uncertainty, EU officials said there was growing acceptance among key euro zone member states that further private sector involvement in reducing Greece's debt burden may have to be forced, not voluntary, something that has been ruled out up to now.
Some countries are working under very aggressive scenarios, one EU official said. Let's be serious, everybody knows that a 50 percent haircut, as Germany is asking for, is not a voluntary move.
In July, private sector investors agreed to contribute 50 billion euros to reducing Greece's debt pile via a debt buyback and swap agreement, which equated to a 21 percent writedown. That is now seen as insufficient to make Athens' debts sustainable.
Greece remains mired in recession and its overall debt is forecast to climb to 357 billion euros ($492 billion) this year, or 162 percent of annual economic output -- which few economists believe can be paid back.
The Financial Times reported that plans to strengthen the banking system, another key plank of the discussions, would fall short of market expectations.
Latest official estimates put the banks capital shortfall at less than 100 billion euros, the FT said, compared with a recent IMF report putting the funding hole at 200 billion and analysts' estimates of 275 billion or more.
With a senior German government source saying Berlin remained resolutely opposed to the ECB backstopping the rescue fund, euro zone officials have told Reuters that an alternative model, whereby the EFSF could underwrite a portion of newly issued euro zone debt, is also on the table.
By guaranteeing the first 20 to 30 percent of any losses, the 440 billion euro EFSF could be stretched three to five times further.
However, analysts are unconvinced that a leverage plan involving a guarantee on first losses would succeed, warning that it could create a two-tier structure in some bond markets and would be meaningless without an explicit commitment from the ECB to go on buying at-risk debt, something it has been reluctant to do.
While Europe's leaders rush to stop a larger writedown of Greek debt infecting others in the euro zone, ordinary Greeks are raging at the prospects of several more years of pain as the price of help from international lenders.
Greek protesters marched on parliament on Thursday, raising the prospect of more violence in strikes against austerity measures parliament is poised to approve to try to stave off bankruptcy.
Running battles between black-clad demonstrators and riot police on Wednesday left streets in central Athens covered with smoldering rubbish and lumps of masonry hacked off buildings in a repeat of clashes seen in anti-austerity protests in June.
(Writing by Mike Peacock; editing by Janet McBride)