* Franco-German demands split EU
* EU Commission criticises proposals, Merkel stands firm
* Lack of progress on reforms could unsettle markets (Adds Merkel quotes)
By Timothy Heritage
BRUSSELS, Oct 27 (Reuters) - The European Union struggled on Wednesday to ensure tensions over Franco-German calls to change the EU treaty do not threaten a summit deal on strengthening the bloc’s budget rules to avert new sovereign debt crises.
EU leaders are expected at talks in Brussels on Thursday and Friday to approve an Oct. 18 agreement by a task force of finance ministers to impose sanctions on member states that violate budget deficit and debt limits. [ID:nLDE69I1FB]
But Germany and France, the EU’s dominant powers, have upset many of their partners by reaching a deal independently to push for changes to the bloc’s fundamental treaty which they say are needed to guarantee long-term fiscal discipline.
“There will be a hot discussion on treaty change,” said a senior EU diplomat. But he added: “We will approve the task force report in the shape it was agreed.”
Germany wants limited amendments to the EU’s Lisbon treaty to allow for a permanent system to handle sovereign debt crises in countries that use the euro and has threatened to block the other reforms if no deal is reached on treaty alterations.
Such an outcome could unsettle financial markets looking for legal certainty and already worried by debt problems in eurozone countries such as Portugal, Ireland and Greece. [ID:nLDE68T0MG]
The EU executive, the European Commission, kept pressure on German Chancellor Angela Merkel and French President Nicolas Sarkozy to abandon their proposals, unveiled at talks in the French town of Deauville on Oct. 18.
“Look back at what had to happen with the Lisbon treaty. We needed 10 years to bring that treaty into being. So for heaven’s sake, I think it would be irresponsible, and I say that again, if we were to reopen the Pandora’s box,” European Justice Commissioner Viviane Reding told reporters in Brussels.
But Merkel stood her ground. She faces pressure in Germany to show she has won something in exchange for bowing to French demands to let the sanctions procedure for deficit and debt sinners be less tough than previously expected. [ID:nLDE69H2DD].
“The new rescue mechanism has to be legally sound. This will only succeed if there is a change in the EU treaties,” Merkel told the Bundestag lower house. [ID:nLDE691WY]
“Even with the toughest stability sanctions, we cannot rule out 100 percent that we will one day face an extreme crisis again that threatens the overall stability of the euro zone.”
Moves to reform the Stability and Growth Pact, which sets out the EU’s budget rules, began in earnest after leaders agreed in March on the need for closer economic coordination after Greece’ debt crisis exposed flaws in the pact.
Germany, Europe’s biggest economy, demanded new rules as the price for bailing out Greece and providing a wider safety net for all euro zone states in May — the 440-billion-euro ($607.6-billion) European Financial Stability Facility.
EU finance ministers agreed in September on a “semester” of economic policy coordination under which countries will submit their annual budgets for review by the Commission and other member states before they are adopted at a national level.
But despite the finance ministers’ agreement on tighter budget rules [ID:nLDE69I1FB], unity is threatened by the Franco-German calls for treaty change and the fact that Merkel and Sarkozy made a deal without consulting other countries.
EU envoys say about half the other EU states have criticised their deal, particularly German demands to make it possible to suspend the voting rights of states which seriously violate the principles of Economic and Monetary Union. [ID:nLDE69Q0H2]
Berlin also favours the development of national insolvency procedures under which lenders to euro zone governments would for the first time face debt write-downs in a financial crisis.
Treaty changes require the backing of all 27 EU countries and the European Parliament. Some states, such as Ireland, could struggle to win public backing. [ID:nLDE69Q0H2]
Financial markets have not reacted much to the EU divisions of the past week, but EU leaders are aware this may not last.
“If there is not a deal or an agreement on how to proceed at the summit, I’d say it would be a bit premature to upset markets ... but I guess they would start to get a bit spooked if there was no deal in the longer term,” a senior EU diplomat said. (Additional reporting by Marcin Grajewski and by Dave Graham in Berlin; editing by Elizabeth Fullerton)