Germany's Angela Merkel expects European leaders to produce a work plan for Greece at a summit on Sunday, possibly including a permanent mission of international lenders to monitor its debts, sources from her party quoted her as saying on Tuesday.

Euro zone leaders meet on October 23 to discuss further aid for Greece, with countries such as Germany and the Netherlands frustrated by Athens' lack of progress on privatization and other reforms. Tighter controls are high on the agenda.

Merkel told her Christian Democrats (CDU) the summit should find ways to ensure the euro zone rescue fund, the European Financial Stability Facility, is used effectively, but that leveraging it via the European Central Bank had been ruled out, party sources said.

CDU sources present at a meeting with the Chancellor said she expected the summit to agree on sending countries that flout EU budget deficit rules to court, a move which could satisfy banks which have urged European policy makers to toughen their stance.

Markets rallied last week on high hopes for the summit but Germany's Finance Minister Wolfgang Schaeuble on Monday tempered expectations for the summit saying it would not produce a miracle cure.

The euro fell for a second day against the dollar on Tuesday, pressured by weak German investor sentiment data, a warning on France's triple-A credit rating and fading hopes of a comprehensive solution to the debt crisis.

Schaeuble also said European governments would adopt a five-point strategy expected to include a plan to recapitalize banks and reduce Greece's debt mountain by asking private creditors to accept steeper writedowns than the 21 percent losses agreed last July.

The head of the Institute of International Finance bank lobby group held a meeting on Monday with Herman Van Rompuy, the EU official who organizes summit meetings, to discuss bank recapitalization and haircuts on Greek debt, an EU diplomat said on Tuesday.

Greece's overall debt is forecast to climb to 357 billion euros ($490 billion) this year, or 162 percent of annual economic output -- a level economists agree is unsustainable.

To reduce this mountain, euro zone leaders are racing to convince banks to accept voluntary writedowns of up to 50 percent on their sovereign holdings. At the same time, they are trying to agree on a blueprint for recapitalizing financial institutions at risk from the deepening crisis.

(Reporting by Andreas Rinke; Editing by Ruth Pitchford)

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