Europe pins hopes on ECB as crisis fears spread

MADRID/ROME (Reuters) - The euro rose and borrowing costs for crisis-hit euro zone countries fell on Wednesday amid speculation the ECB could take decisive steps to combat turmoil that has stoked contagion worries in the United States and Asia.

An 85 billion euro ($110.7 billion) EU/IMF rescue of Ireland last weekend and public assurances from European leaders that the euro will be defended at any cost have failed to impress investors who are targeting Portugal, Spain and Italy in a test of the EU's resolve and crisis-fighting resources.

Reflecting global concerns about the euro zone crisis, the U.S. Treasury announced late on Tuesday that it would send an envoy to Europe this week to discuss the turmoil with governments in Berlin, Madrid and Paris.

G20 sources also told Reuters that deputy finance ministers from the group of major rich and developing nations had discussed Europe's financial plight in a conference call on Monday, although they described the call as routine.

A day after investors pushed the risk premiums on Spanish and Italian bonds to euro lifetime highs, speculation grew that the European Central Bank could unveil new anti-crisis measures after it meets on Thursday, including possibly new purchases of government bonds.

The obstacles to such a step are high. An ECB bond purchase program launched in May after Greece was bailed out has been controversial within the bank, and influential Bundesbank head Axel Weber has called publicly for it to be scrapped.

But traders said the ECB was supporting the market through bond purchases on Wednesday. The Frankfurt-based central bank declined to comment.

A rising number of economists say the ECB may need to throw out its rule book to save the euro, particularly as governments seem to be running out of ideas for restoring confidence in their bold 12-year old currency project.

"The markets are expecting (the ECB) to announce some upscaling of their purchases of government debt and perhaps other unorthodox measures," said Gilles Moec, an economist at Deutsche Bank. "There is a feeling that things have got to a point where the ECB has to do more."

French Economy Minister Christine Lagarde told reporters in Paris that she welcomed the "extremely active role" that the ECB was playing alongside EU governments.

EURO BREAKUP TALK "WRONG"

The euro rose to $1.3125 after dipping to a 10-week low against the dollar on Tuesday and the premium investors demand to hold Portuguese, Spanish and Italian bonds instead of German benchmarks fell.

European bank stocks also rebounded, with Spain's Banco Santandar and BBVA each up over 7 percent after the Spanish government announced new steps to reduce the national debt.

Debt auctions in Portugal and Germany, however, exposed persistent jitters. Lisbon's borrowing costs surged in a 12-month bill auction and a German 5-year note sale drew the weakest demand in half a year.

Manufacturing data reminded markets of the economic divergences plaguing Europe, while at the same time showing production in China and India charging ahead.

For a third day running, policymakers tried to reassure markets of their determination to stabilize the euro zone in the face of a debt crisis that has haunted it for a year, and in recent weeks raised doubts about the common currency's future.

Klaus Regling, a German official who heads the temporary rescue mechanism set up by the EU half a year ago, said in Singapore that speculation the euro would disintegrate was plain "wrong" and that no member would leave the bloc.

Still, reflecting how worried Europe's partners have become, the U.S. Treasury said it would send Undersecretary for International Affairs Lael Brainard to Europe this week to discuss the turmoil.

Citigroup's chief economist warned this week that euro zone turmoil may be the "opening act" of a global sovereign debt crisis that could infect the United States and Japan.

EU plans to make private bond holders shoulder some of the pain from any sovereign debt restructuring after mid-2013 have led investors to reassess the risk of putting their money in the government bonds of high-debt countries.

ECB President Jean-Claude Trichet has cautioned against underestimating the determination of policymakers to stabilize the euro zone, but options for stopping the rot appear limited.

LIMITED OPTIONS

Germany has resisted pressure from countries like France to turn the euro zone into a "fiscal union" -- a step which could help the bloc address its economic imbalances, but which would require members to sacrifice sovereignty over economic policy for the good of the group.

Chancellor Angela Merkel is also skeptical about putting up more funds for bailouts, concerned German taxpayers could end up underwriting the rescues of countries her government believes have become targets because of economic mismanagement.

"Our taxpayers won't go along with everything," German Economy Minister Rainer Bruederle warned on Wednesday.

But pressure from Germany's partners is mounting. Portugal's Treasury Secretary Carolos Pina told Reuters the EU needed to "deepen its budget and create a European Treasury" to defend the euro -- a move that would be anathema in Berlin.

Peter Bofinger, a member of the "wisemen" panel of economic advisers to the German government, also pressed Merkel to get off the fence and decide whether she was ready to defend the euro or see it fail.

(Writing by Noah Barkin; editing by David Stamp)