Euro zone Big Four confer after fifth state seeks aid

PARIS/BRUSSELS (Reuters) - Finance chiefs of the euro zone's four biggest economies will hold last-minute talks in Paris on Tuesday evening to try to narrow differences on the currency area's future after Cyprus became the fifth country to request a bailout.

Ministers from Germany, France, Italy and Spain will discuss how to manage the crisis in the short term and proposals for closer long-term fiscal and banking integration to prepare for a European Union summit starting on Thursday.

Financial markets are on edge and international pressure for decisive action is rising but the summit, the 20th since the bloc's debt problems began in early 2010, is not expected to produce a lasting solution to the crisis.

European Commission President Jose Manuel Barroso underlined just how much was at stake.

"It is not only economic integration, it is also the overall economic confidence in the euro area, and indeed, our commitment to the European project," he said in a speech in Brussels. "This is why we need to be bold and define the way forward."

A report prepared by the EU's top four officials suggests the euro zone could create a treasury for the single currency and jointly issue euro bonds in the medium term as the final stage of a fiscal union.

However, German Chancellor Merkel, who leads Europe's biggest economy and the main contributor to its bailout funds, again ruled out on Monday any sharing of debt or bank liabilities as "economically wrong and counter-productive".

The finance ministers' session was called at such short notice - in an apparent rush to repair damage from a public rift between Merkel and leaders of the other three states when they met in Rome last Friday - that one finance minister's press staff only learned of the invitation on Tuesday morning.

The four finance chiefs are expected to try to paper over those differences before Merkel and French President Francois Hollande hold a pre-summit meeting on Wednesday.

Cyprus, the 17-nation currency area's third smallest economy with just 1 million residents, added drama to a fraught week by applying for rescue loans on Monday.

HALF ITS ECONOMY

Two euro zone sources said the East Mediterranean island, with an outsize financial sector heavily exposed to neighboring Greece, may need up to 10 billion euros in emergency financing, more than half its 17.3 billion euro annual output.

While the sum is easily within the range of the European Financial Stability Facility (EFSF) bailout fund, it sets an awkward precedent and may lead to demands for collateral or for private bondholders to take a write-down as they did in Greece.

Cyprus needs to plug a 1.8 billion euro capital shortfall in its second largest lender by June 30. Potential aid could be more comprehensive to cover fiscal requirements, Finance Minister Vassos Shiarly told Reuters.

Nicosia is believed to have applied to the EU for aid after exhausting attempts to secure loans from either China or Russia, a close ally, in an apparent effort to avoid the tough conditions and intrusive monitoring of an EU/IMF program.

"The exact number has not been decided yet. It was to be 6 billion for the state financing and 2 billion for the banks but that is optimistic - it is more likely to be seven and three - up to 10 billion euros in total," one euro zone official said.

On Monday, Spain formally requested up to 100 billion euros in rescue loans to recapitalize a banking sector that is weighed down by bad loans from a burst real estate bubble.

It is seeking to avoid the political humiliation and partial loss of sovereignty involved in a full state bailout program of the kind granted to Greece, Ireland and Portugal, even though the IMF and EU authorities will still have to monitor the aid.

Spanish and Italian bond yields rose again on Tuesday as skepticism set in before the EU summit. Spain had to pay the highest yields since last November to sell 3.08 billion euros in short-term debt as demand from its ailing banks dwindled.

The euro weakened marginally against the dollar.

CONTAGION

Investors want to see bold moves to underpin the European currency union and halt the inexorable contagion from one debt-stricken country to another. But with 27 EU countries and 17 in the euro zone, quick steps are one thing Europe can't take.

The Brussels summit is expected to agree on a growth package pushed by France worth around 130 billion euros ($162 billion) in infrastructure project bonds, reallocated regional aid funds and European Investment Bank loans.

Leaders will also discuss proposals for a banking union but while they are likely to agree to give the European Central Bank power to supervise big cross-border banks, Merkel is resisting any joint deposit guarantee or common bank resolution fund.

In Washington, U.S. Treasury Under Secretary Lael Brainard, who has been handling financial diplomacy with Europe, urged EU leaders to put "more flesh on the bones" of their plans for tackling the debt crisis at this week's summit.

"The particulars on how they go forward and how they design their firewall, how they design their policies, those are things that at the end of the day sit with those European leaders," she said in an interview with Reuters. "We're all looking forward to seeing some of the specifics.

Jim O'Neill, chairman of Goldman Sachs Asset Management, told Reuters the euro zone crisis could be solved easily if Merkel and other leaders showed the political will.

"The euro crisis is in some ways mind-bogglingly simple to solve ... because it isn't economics, it's politics," O'Neill told Reuters in an interview.

"If Angela Merkel and her colleagues stood there together with the rest of the euro area ... and if they behaved as a true union this crisis would be finished this weekend," he said.

The euro area had no current account deficit with the rest of the world, did not need external financing, had a lower debt-and-deficit-to-GDP ratio than the United States or Japan, he said. "And yet we have this almighty mess."

"MEDIUM-TERM PERSPECTIVE"

The EU's top four officials - European Council President Herman Van Rompuy, Barroso, ECB President Mario Draghi and Euro group chairman Jean-Claude Juncker - circulated proposals to euro zone leaders ahead of the summit.

"In a medium-term perspective, the issuance of common debt could be explored as an element of such a fiscal union and subject to progress on fiscal integration," said the report, obtained by Reuters.

"Steps towards the introduction of joint and several sovereign liabilities could be considered, as long as a robust framework for budgetary discipline and competitiveness is in place to avoid moral hazard and foster responsibility and compliance," it said.

The EU officials proposed a "criteria-based and phased" approach towards issuing common debt, in which progress in the pooling of decisions on budgets would be accompanied with commensurate steps towards the pooling of risks.

"Several options for partial common debt issuance have been proposed, such as the pooling of some short-term funding instruments on a limited and conditional basis, or the gradual roll-over into a redemption fund," it said.

(Additional reporting by Michele Kambas in Nicosia, Jan Strupczewski in Brussels, Georgina Prodhan in Vienna, Lesley Wroughton and Chrystia Freedland in Washington; writing by Paul Taylor; editing by Philippa Fletcher)

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