Efforts to secure a deal to tackle the euro zone debt crisis are stalled over methods to increase the firepower of the region's bailout fund, French President Nicolas Sarkozy said on Wednesday.
Sarkozy told French parliamentarians the dispute was holding up negotiations and he was prepared to fly to Frankfurt later on Wednesday to talk with German Chancellor Angela Merkel and try to break the deadlock ahead of a make-or-break European leaders' summit on Sunday.
French sources later confirmed Sarkozy would travel to Germany, where he is also expected to meet outgoing European Central Bank President Jean-Claude Trichet.
While France has argued the most effective way of leveraging the firepower of the European Financial Stability Facility is to turn it into a bank which could then access funding from the ECB, both the central bank and the German government have opposed this.
In Germany, the coalition is divided on this issue. It is not just Angela Merkel who we need to convince, Sarkozy told the parliamentarians, according to Charles de Courson, one of the legislators present.
His comments fueled doubts about whether euro zone leaders will be able to agree a clear and convincing plan when they meet on Sunday.
Failure to do so would further undermine financial markets' already shattered 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.
Uncertainty increased after Moody's ratings agency issued a double-notch downgrade of Spain's credit rating a day after the agency warned France its triple-A rating could come under pressure and as Greeks began their biggest strike in years in protest at a painful austerity drive designed to avert default.
The Spanish rating cut, which highlighted the threat of contagion from debt-stricken Greece, tempered a sharp rally in shares.
Merkel warned late on Tuesday that leaders would not solve the debt crisis at a single meeting.
These sovereign debts have been built up over decades and therefore one cannot resolve them with one summit but it will take difficult, long-term work. Nonetheless, I do think we will also be able to take relevant, important decisions, she said.
The hope remains that Sunday's summit will agree 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 prevent contagion to bigger economies.
You know the French position and we are sticking to it. We think that clearly the best solution is that the fund has a banking license with the central bank, but everyone knows about the reticence of the central bank, French Finance Minister Francois Baroin told reporters in Frankfurt.
Everyone also knows about the Germans' reticence. But for us that remains ... the most effective solution.
Euro zone officials have told Reuters that an alternative model, whereby the EFSF can underwrite a portion of newly issued euro zone debt, is also on the table.
By guaranteeing the first 20-30 percent of any losses, the EFSF could stretch three to five times further. With about 300 billion euros of its 440-billion-euro capacity still available, the fund could be expanded to more than 1 trillion euros, and give markets pause for thought.
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 European Central Bank to go on buying at-risk debt.
On paper this solution has some merits because it is expedient ... but is in fact fraught with complications that are very likely to make it fail, Shahin Vallee, an analyst with Bruegel, a leading think-tank, said in a research paper.
As well as trying to strengthen the rescue fund, euro zone leaders are racing to convince banks to accept voluntary writedowns of up to 50 percent on their Greek sovereign holdings. They are also trying to agree on a blueprint for recapitalizing financial institutions at risk from the deepening crisis.
A Reuters polls of economists predicted European leaders will probably ask private investors to shoulder losses of around 50 percent on holdings of Greek government debt, the top end of a range suggested by officials last week.
Greece remains mired in recession and its overall debt is forecast to climb to 357 billion euros ($489 billion) this year, or 162 percent of annual economic output -- which few economists believe can be paid back.
Moody's cut Spain's bond rating to A1, from Aa2, the third of the major agencies to act in recent weeks and taking it a notch below the ratings of Standard & Poor's and Fitch.
The agency's reasoning may focus minds ahead of Sunday's summit, highlighting the lack of resolution to the bloc's crisis rather than particular Spanish policy shortcomings.
Since placing the ratings under review in late July 2011, no credible resolution of the current sovereign debt crisis has emerged and it will in any event take time for confidence in the area's political cohesion and growth prospects to be fully restored, Moody's said.
While Europe's leaders rush to stop a larger writedown of Greek debt infecting others in the euro zone, for ordinary Greeks, the cuts demanded of their country in return for help means several years of pain.
Black-clad demonstrators hurled stones and fire bombs at police in front of the Greek parliament on Wednesday as tens of thousands rallied for a nationwide general strike to coincide with a vote on painful new austerity measures.
The mood was furious among demonstrators, fed up after repeated doses of austerity and increasingly hostile to both their own political leaders and international lenders demanding ever tougher measures to cut Greece's towering public debt.
Who are they trying to fool? They won't save us. With these measures the poor become poorer and the rich richer. Well I say: 'No, thank you. I don't want your rescue', said 50-year public sector worker Akis Papadopoulos.
The austerity package mixes deep cuts to public sector pay and pensions, tax hikes, a suspension of sectoral pay accords and an end to the constitutional taboo against laying off civil servants.
A first vote, on the government's overall bill, will be held on Wednesday night, with a second vote on specific articles expected some time on Thursday. It is expected to pass even though Greece has sunk deeper into crisis, despite repeated doses of austerity.
($1 = 0.731 Euros)
(Additional reporting by Lefteris Papadimas and Renee Maltezou in Athens, Elizabeth O'Leary in Madrid and Michael Shields in Vienna; Writing by Mike Peacock, editing by Janet McBride)