WRAPUP 7-Battle over Spain, Italy rescue erupts at EU summit
* EU leaders divided on crisis response
* Italy, Spain hold up growth package to demand urgent support
* Focus on using EU rescue funds to buy Spain, Italy bonds-sources
* Merkel says budget control must come before debt sharing
By Luke Baker and Julien Toyer
BRUSSELS, June 28 (Reuters) - Italy and Spain, battling searing market pressure in the euro zone's widening debt crisis, held up agreement on measures to promote growth at a European Union summit on Thursday to demand urgent action to bring down their borrowing costs.
Italian Prime Minister Mario Monti and his Spanish counterpart, Mariano Rajoy, refused to sign off on a 120 billion euro ($149 billion) growth package until EU paymaster Germany approved short-term measures to ease their cost of credit, officials said.
Hours later than planned, European Council President Herman Van Rompuy came out to announce a deal in principle on measures to stimulate infrastructure investment and give more capital to the EU's soft-lending arm, the European Investment Bank.
"There's no blockage, we keep on working and we move on," he told a belated news conference, playing down reports of a row.
But Italy, Spain and some other countries said they wanted to see steps to allow euro zone rescue funds to buy their government bonds and support their banks before they would give final approval.
"There's an epic battle going on between those who seek immediate and unconditional solidarity and those who seek to fundamentally change the way European economies are run and put Europe on a course of stability, discipline and growth," one EU official reported after nearly eight hours of debate.
Another said Socialist French President Francois Hollande, the strongest backer of the growth pact, had also raised concerns and sought a delay in introducing stricter measures to enforce EU budget discipline. There was no comment from the French camp.
Merkel cancelled a planned news briefing as the leaders argued over the EU's future long-term budget and the growth package. The 27-nation EU summit agenda was turned upside down with plans for euro zone leaders to hold a late-night discussion on the future of their troubled 17-member currency union.
It was the 20th EU summit since the sovereign debt crisis began in early 2010 after Greece disclosed its public deficit was far higher than previously reported.
Policymakers played down any prospect of a rapid solution to the turmoil which has forced Greece, Ireland, Portugal and now Spain and Cyprus to seek international bailouts.
As the leaders wrangled, Italy was beating Germany 2-1 in the Euro 2012 soccer semi-final, the underdog knocking the favourite out of the contest.
Reflecting public anxiety about the future of the single currency, European Parliament President Martin Schulz told the summit: "Today, people throughout Europe are casting worried eyes towards Brussels, towards this summit meeting, because they fear that our European project is one step away from disaster."
Positions were so far apart that even before Thursday's meeting began EU sources said there was the prospect of another summit in mid-July to try to bridge the differences.
In draft summit conclusions, subject to amendment on Friday, the leaders were set to ask the EU's top four officials to produce a detailed, time-bound roadmap to a genuine economic and monetary union by December.
But markets may not wait that long.
On the summit sidelines, deputy finance ministers were working on urgent measures to support Madrid and Rome, seen as too big to bail out, that euro zone leaders may adopt on Friday.
Italy's benchmark borrowing costs hit six-month highs at auction on Thursday, piling pressure on Monti to ease squeeze concessions out of Germany.
Rome and Madrid have been pleading for help but had received a cool response from Berlin and other capitals so far.
Three EU sources said work was focused on using the euro zone's temporary EFSF rescue fund and a future permanent ESM bailout fund to buy new Spanish and Italian bonds as they were issued to underpin their bond auctions.
The funds will have a maximum firepower of 500 billion euros ($625 billion) once the ESM is fully stocked in 2013, minus 100 billion euros already earmarked to aid Spanish banks.
The sources said the preferred creditor status of ESM loans to Spain, which has spooked investors, was likely to be removed if Madrid issues covered bonds backed by state assets or tax revenues.
Italy and Spain would still have to request assistance, which they have been loath to do, and would be subject to fiscal policy conditions and international monitoring. But they might not be required to do more in austerity and structural reforms than they have already undertaken, the sources said.
"NEIN! NO! NON!"
Merkel was being urged at home to hang tough and reject all efforts to make Germany underwrite European borrowing or banks, which some of her partners say may be the only way to save the single currency.
"Nein! No! Non!" shouted a headline splashed across the front page of the normally sober German business daily Handelsblatt.
Monti was also under mounting domestic pressure to achieve results in reducing Rome's borrowing costs or risk seeing his technocratic government fall within months as the centre-right and centre-left parties that support him jockey for position before an election due in 2013.
Van Rompuy and European Commission President Jose Manuel Barroso have set long-term goals of creating a euro zone treasury to issue joint bonds in the medium-term, and establishing a banking union with central supervision, a joint deposit guarantee and a resolution fund.
Merkel insists that fundamental reforms to give European Union authorities power to override national budget and economic policies must come before any further shared liability.
Germany has enjoyed an export boom even as the crisis has spread, removing any sense of urgency among voters for radical steps to support other countries.
The euro hit a three-week low and world stocks fell as investors bet that this latest summit would fail to produce concrete measures to tackle the crisis, sending 10-year Spanish government bond yields above the danger level of 7 percent.
France's Hollande advocates joint "eurobonds", which would bring down borrowing costs for the weak because the pool of guarantors would include the strongest - principally Germany.
Germany does not want to use its credit rating to support others unless they share control of tax and spending powers first. Dutch premier Mark Rutte sided with Merkel in arguing against any early move to share liability.
"It's crucial for us to avoid taking measures that would ease pressure on southern Europe to reform. That is why I seriously question a rapid transition to a banking union, or eurobonds," he told parliament in The Hague. "That would result in a sort of 'paracetemol effect' for southern Europe, like the effect performance enhancers have on athletes."
Finnish Europe Minister Alex Stubb told Reuters that Europe should prepared to live in a state of crisis for the rest of the decade. But he said a stronger and more resilient continent would eventually emerge.
"It is an existential crisis, but it's probably the best crisis we've had. It's forcing European leaders to take very difficult decisions and as we all know very few difficult decisions have been taken in a relaxed atmosphere," he said.
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