A flare-up over the European Central Bank and political turmoil in Italy kept the euro zone on edge on Tuesday on the eve of a summit meant to confront the currency bloc's worsening sovereign debt crisis.

Just 24 hours before European leaders are due to adopt a plan to reduce Greece's debt burden, fortify European banks to withstand bond losses, and scale up the euro zone rescue fund to prevent market contagion, disputes raged in Rome and Berlin.

There was no sign of a deal in negotiations to reduce Greece's debt to private sector bondholders, and uncertainties remained over the size of a planned bank recapitalization and the scope for leveraging the rescue fund.

As a result, few figures may emerge from Wednesday's closely watched summit, expected to run late into the night.

Chancellor Angela Merkel, fighting to secure parliamentary backing for euro zone rescue measures, said Germany opposed a phrase in the draft summit conclusions urging the ECB to go on buying troubled states' bonds.

The draft seen by Reuters supports a continuation of non-standard measures in the current exceptional financial market environment.

This sentence is not agreed with us, Merkel told reporters, adding that Germany -- a country wedded to central bank independence -- did not want a declaration from politicians telling the ECB what to do.

An opposition lawmaker said the German parliament would try to point the ECB in the opposite direction, expressing the expectation in a joint motion on Wednesday that the ECB would stop its bond purchases on the secondary market.

Test votes in her center-right coalition showed Merkel was likely to win a narrow majority of her own supporters, but 16 dissidents would either abstain or vote against the motion.

The euro and European stocks slipped and safe-haven German bonds rose after Merkel's comments since continued ECB support is widely seen as crucial to stabilizing the markets.

In Rome, Prime Minister Silvio Berlusconi's center-right coalition was split after the cabinet failed to agree on Monday on raising the retirement age, a key economic reform demanded by Italy's EU partners as a condition for supporting its bonds.

Berlusconi, mired in scandals and fading in approval ratings, responded truculently to public pressure from French President Nicolas Sarkozy and Merkel at an EU meeting on Sunday, saying that no one could teach Italy lessons.

The European Commission said the aim was not to humiliate Italy, but to ensure that a member state meets its commitments on budget discipline and economic coordination.

It's not about challenging sovereignty, it's not about lecturing, it's not about humiliating, said the Commission spokesman on economic issues, Amadeu Altafaj.

Berlusconi's Northern League coalition partners oppose raising the retirement age to 67 from 65, and their leader Umberto Bossi told reporters the government could fall over the EU reform demands. there was growing talk of early elections next spring.

As the coalition parties held separate meetings, President Giorgio Napolitano said in a statement Italy must do everything to reduce the risk to government bonds by making its commitment to cut public debt more credible and boosting growth.


The euro zone's number three economy is at the center of the storm, despite European Central Bank intervention to buy its bonds, because it needs to issue some 600 billion euros in bonds in the next three years to refinance maturing debt.

Italy has the euro zone's largest sovereign bond market, with public debt of 1.8 trillion euros, 120 percent of GDP.

Italy was not the only unresolved item on the summit agenda and Bank of England governor Mervyn King voiced skepticism from outside the euro zone as to whether the currency area's leaders would be able to find solutions.

Even on July 21 there was a package which they held out as being the solution to it. The underlying problems hadn't changed at all and they won't change, King told the House of Commons treasury committee, saying at best the leaders might achieve a breathing space.

Tough negotiations were continuing between euro zone governments and Greece's private bondholders over the scale of a write-down they will have to accept on Greek debt holdings.

Governments are demanding that banks and insurers accept a 60 percent haircut as part of a second rescue package to make Athens' debt mountain, set to reach 160 percent of economic output this year, more sustainable.

Bank negotiators have offered a 40 percent write-down and warned that forcing them into deeper losses would amount to a forced default with what banks say will be devastating consequences for the European financial system.

EU diplomats said the outcome of the game of chicken between governments and banks was uncertain, but some forecast a last-minute deal on a 50 percent write-down.

Greek Prime Minister George Papandreou said: I hope that tomorrow we will come to decisions, this is our partners' will.

Tomorrow we want to put an end, turn a page, in order for the country to move forward.


Many uncertainties remain also over complex options to increase the firepower of the 440 billion euro ($600 billion) European Financial Stability Facility so it can prevent contagion spreading from Greece to Italy and Spain.

A working paper circulated to German lawmakers on Monday set out two options that might be used separately or in tandem to provide partial insurance on new Italian and Spanish bonds and to attract foreign sovereign and private investors via a special purpose investment vehicle (SPIV).

The International Monetary Fund is considering taking part in the scheme but has not made a decision yet, euro zone officials told Reuters on Tuesday.

However, much of the detail of the leveraging may be left until after Wednesday night's summit, due to start with a short meeting of the full 27-nation European Union at 1600 GMT, followed by a lengthy session of the 17 euro zone members.

Even if the leaders agree on the outlines of a leverage plan for the EFSF, the arrangements would take several weeks to put in place and most euro zone leaders are counting heavily on the ECB to go on buying Italian and Spanish bonds.

ECB President Jean-Claude Trichet, who retires next week, had signaled that the central bank was looking to withdraw from the deeply controversial bond-buying policy once the EFSF gained its new powers to intervene on bond markets.

But EU officials say they are counting on his successor, Mario Draghi of Italy, to continue the purchases as long as is necessary to stabilize the bond markets.