Greece, Italy top agenda at EU finance chiefs meeting

BRUSSELS (Reuters) - European Union finance officials will discuss Greece's intractable debt crisis and the worsening situation in Italy on Monday, with the threat of contagion to the euro zone's third-largest economy growing.

Herman Van Rompuy, the president of the European Council, will meet European Central Bank President Jean-Claude Trichet and Jean-Claude Juncker, the chairman of the Eurogroup, for talks in Brussels around midday (1000 GMT), ahead of a meeting of the 17 euro zone finance ministers later on Monday.

Van Rompuy's spokesman described the gathering, which also includes European Commission President Jose Manuel Barroso, and the EU's economic and monetary affairs commissioner, Olli Rehn, as a "coordination, not a crisis meeting," and said Italy would not be on the agenda.

However, senior EU sources said it would be impossible not to discuss Italy following a large sell-off in Italian bonds and stocks that the Italian media have dubbed "black Friday."

Austria's Finance Minister Markia Fekter said Italy was among the issues to be discussed, saying ministers wanted to quiz Italy about how it was handling the situation.

"We have a Eurogroup meeting today and tomorrow Ecofin. We will (discuss) the IMF decisions and we will also have questions for the Italian minister there," she told reporters.

Shares in Italy's biggest bank, Unicredit Spa, were volatile on Monday after losing 7.9 percent on Friday, partly because of worries about the results of stress tests of European banks that will be released on July 15. Other banks stocks also fell heavily.

The cost of insuring Italian debt against default jumped to a record high, with five-year credit default swaps rising 30 basis points to 279 basis points, according to data monitor Markit. The cost of insuring Greek, Portuguese and Irish debt against default also rose.

The sell-off has increased fears that Italy, with the highest sovereign debt ratio relative to GDP in the euro zone after Greece, could be next to get dragged into crisis. If that came to pass, the euro zone's existing rescue mechanism, the EFSF, would have insufficient funds to help.

The 10-year yield spread between Italian and German debt widened to a euro-era high of 258 basis points and bond yields neared the 5.5-5.7 percent area which some bankers say will start putting heavy pressure on Italy's finances.

The market pressure is due in part to Italy's high sovereign debt and sluggish economy, but also to concern that Prime Minister Silvio Berlusconi may be trying to push out his long-time finance minister, Giulio Tremonti, who has promoted deep spending cuts to control the budget deficit.

"We can't go on for many more days like Friday," a senior ECB official told Reuters. "We're very worried about Italy."

German newspaper Die Welt quoted an unnamed ECB source as saying the EFSF may have to be doubled in size to 1.5 trillion euros if it is to be capable of coming to the aid of Italy.

ACCEPTING DEFAULT?

Monday's gathering of finance ministers will focus on a second bailout package for Greece and the need to secure the private sector's involvement in the assistance program, which is expected to total 110 billion euros.

Germany, the Netherlands, Austria and Finland are determined that banks, insurers and other private holders of Greek government bonds should bear some of the costs of helping Athens -- up to 30 billion euros of the total package.

But after weeks of negotiations with bankers represented by the Institute of International Finance, there has been next to no progress on agreeing a formula acceptable to all sides.

Initially talks focused on a complex French plan for private creditors to roll over up their holdings of Greek debt, buying new bonds as their existing ones matured.

But as that plan has floundered, Berlin has revived a proposal to swap Greek bonds for longer-dated debt that would extend maturities by seven years. Proposals to buy back Greek bonds and retire them have also been floated.

However, both those plans would likely be regarded by ratings agencies as a default, or at best a selective default, which could have profound repercussions for global financial markets. The ECB has said it will not accept anything that is termed a default, a position Germany also maintains.

"All of the efforts so far have been in order to avoid default because no one is quite sure what its knock-on effects would be," one EU official said. "Nobody wants a default -- it's not an option."

In a buy-back, the EFSF bailout fund might buy Greek bonds from the market, or lend Greece money to do so. However, these schemes would require changes to the EFSF's rules which would require the backing of national parliaments, officials say.

If euro zone finance ministers do back the idea of a buy-back or a debt swap in an effort to move ahead more rapidly with a second package for Greece, it would effectively mean condoning a default in order to achieve a writedown in the value of Greek debt and make its debt mountain more sustainable.

Senior euro zone officials worry that any further delay in putting together a second package -- which Greece wants by early September -- could further poison investors' confidence in weak economies around the region, prompting more contagion.

German Chancellor Angela Merkel's spokesman, Steffen Seibert, said Germany agreed with other euro zone states that a second package for Greece had to be agreed rapidly and said it would top the agenda at talks on Monday.

(Additional reporting by John O'Donnell in Brussels, Silvia Westall in Vienna and Milan/Rome bureaus, editing by Mike Peacock)

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