BRUSSELS (Reuters) - EU leaders meet on Thursday and Friday to discuss how to tackle the euro zone debt crisis and bring about closer fiscal ties among the 17 countries in the single currency bloc.
Markets have rallied in the run up to the meeting and the borrowing costs of many European countries have fallen. Bank stocks are up about 17 percent since the start of last week.
Here are some of the key issues:
Investors hope leaders will at least come up with what would be a roadmap towards euro zone fiscal union -- a framework to control budgets and debt, including strict sanctions for spendthrift states and the ability to bring them to court.
“They will have some movement to close fiscal ties at this week’s summit. Maybe not full agreement, but agreement on the direction they are going in,” said Huw Worthington, a sovereign debt analyst with Barclays Capital.
But investors also want immediate action with a show of muscle after recent disappointment over failed attempts to leverage the euro zone’s rescue fund to 1 trillion euros.
“Markets have priced in a positive result so there is a risk of disappointment,” said Nick Kounis, head of macroeconomic research at ABN Amro, adding that a show of strength was needed.
This show of strength could come in the form of a signal from the European Central Bank that it will continue to support markets, either through lending to banks or buying state bonds.
Leaders could also agree to give more resources to the International Monetary Fund, possibly by allowing euro zone central banks to contribute funds to the IMF, which would then on-lend money to troubled euro zone states.
A wide range of figures is circulating, but there is hope that total commitments could exceed 100 billion euros.
Any comprehensive deal will be based on agreement between France and Germany.
But others may struggle to accept Germany’s demands to take errant euro zone countries to the European Court of Justice, the EU’s highest court. They will also be reluctant to surrender autonomy over their national budgets.
Germany also wants deeper fiscal union to be inscribed in EU law via changes to the EU’s Lisbon treaty, but there is resistance among a number of euro zone and non-euro zone states to such changes, even limited ones.
Instead, negotiators are trying to persuade Germany that most of what it wants for deeper fiscal integration can be achieved without treaty changes, although the ability to take countries to court would not be among the options.
“You may well get agreement that treaty change is being looked at without getting agreement on the text,” said one EU official with direct knowledge of the negotiations. “It was never on the cards that it would be sorted in detail.”
He said EU leaders could issue a statement on Friday “that we need to look at reinforcing fiscal discipline or the excessive deficit procedure at the treaty level.”
For analysts and bankers, the technicalities of any agreement is of secondary importance. Far more significant is whether the commitment to fiscal union is clear enough to give the ECB the political cover to continue to supporting markets through bond-buying and lending to banks.
Last week, ECB President Mario Draghi signalled that the bank stood ready to act if political leaders agree what he called a “fiscal compact,” a reference to a more centralized framework to control national budgets.
Officials in Brussels involved in negotiations ahead of the summit meeting, took heart from his choice of words, which they believe indicate the ECB may ready to act even if real fiscal union remains a distant prospect.
“Draghi called it a compact because that can cover all kinds of legal statements,” said one official. “It can mean a political decision. I read that to mean that the bank needs political cover. It needs something delivered in return but he is not prejudicing the legal form it will take.”
Some are skeptical, however, that such political pledges will be enough.
“It needs to be specific,” said one banker. “Otherwise, it’s not really much of an agreement. If the announcement is along the lines that we want to have treaty changes to enhance governance and we will now consult over the coming weeks, I don’t think that will pass the sniff test for either markets or the ECB.”
Gary Jenkins, a debt specialist with investment bank Evolution Securities, believes the ECB will have little alternative but to continue helping. “What choice does the ECB have? It would be very brave of them to say that’s not enough and then the whole market melts down.”
The euro zone’s central bank is not expected to take dramatic steps next week, however, and is likely to continue supporting markets primarily with loans to banks, where it faces fewer restrictions than when buying country bonds.
It may chose to extend ultra-long loans of up to three years to banks to head off a credit crunch, as well as continuing to support weak countries by buying their bonds.
“The ECB will stop short of large scale quantitative easing,” said James Nixon, chief European economist with Societe Generale. “There won’t be any bazooka but the roughly 5 to 10 billion euros a week of bond-buying will stay with us throughout next year.”
Reporting By John O'Donnell; Additional reporting by Paul Carrel and Marc Jones in Frankfurt and Luke Baker in Brussels. Editing by Jeremy Gaunt.