Sarkozy says euro zone talks stuck, flies to Germany

PARIS/FRANKFURT (Reuters) - Plans to tackle the euro zone debt crisis have stalled with Paris and Berlin at odds over how to increase the firepower of the region's bailout fund, French President Nicolas Sarkozy said on Wednesday.

Sarkozy told French parliamentarians the dispute was holding up negotiations. He then flew to Frankfurt to talk with German Chancellor Angela Merkel in an attempt to break the deadlock ahead of a make-or-break European leaders' summit on Sunday.

A French presidency source said the French and German leaders were meeting other euro zone policy chiefs and International Monetary Fund head Christine Lagarde on the sidelines of an event mark the end of Jean-Claude Trichet's presidency of the European Central Bank.

France has argued the most effective way of leveraging the European Financial Stability Facility is to turn it into a bank which could then access funding from the ECB, but both the central bank and the German government have opposed this.

"In Germany, the coalition is divided on this issue. It is not just Angela Merkel who we need to convince," Sarkozy told the parliamentarians at a lunch meeting, according to Charles de Courson, one of the legislators present.

His comments fueled doubts about whether euro zone leaders will be able to agree a clear and convincing plan when they meet on Sunday.

Failure to do so would further undermine financial markets' already shattered confidence in the currency bloc and its ability to get on top of a two-year-long debt crisis, which threatens the long-term viability of the single currency.

One senior EU official, who is involved in coming up with solutions to the crisis, said the only "circuit-breaker" now was for the ECB to make an explicit commitment to go on buying distressed euro zone debt for "as long as it takes," something Trichet has said should not happen.

That position appeared to be seconded by Barroso, who said in Frankfurt: "The decisive intervention of the ECB in secondary bond markets was and still is a critical element in securing financial stability in the euro area."

Uncertainty over the euro zone's future intensified as Moody's issued a double-notch downgrade of Spain's credit rating a day after the agency warned France its triple-A rating could come under pressure. In Greece, workers began their biggest strike in years in protest at austerity measures.

Merkel warned late on Tuesday that leaders would not solve the debt crisis at a single meeting and reiterated that past errors would not be solved in "one stroke."

"If the euro fails, Europe fails but we will not allow that," she said in Frankfurt.

The hope remains that Sunday's summit will agree new steps to reduce Greece's debt, strengthen the capital of banks with exposure to troubled euro zone sovereigns and leverage the euro zone's rescue fund to prevent contagion to bigger economies.

"You know the French position and we are sticking to it. We think that clearly the best solution is that the fund has a banking license with the central bank, but everyone knows about the reticence of the central bank," French Finance Minister Francois Baroin told reporters in Frankfurt.

"Everyone also knows about the Germans' reticence. But for us that remains ... the most effective solution."

A senior German government source said Berlin remained resolutely opposed to the ECB backstopping the rescue fund.

BANK OR INSURER?

Euro zone officials have told Reuters that an alternative model, whereby the EFSF could underwrite a portion of newly issued euro zone debt, is also on the table.

By guaranteeing the first 20-30 percent of any losses, the EFSF could stretch three to five times further. With about 300 billion euros of its 440-billion-euro capacity still available, the fund could be expanded to more than 1 trillion euros, and give markets pause for thought.

However, analysts are unconvinced that a leverage plan involving a guarantee on first losses would succeed, warning that it could create a two-tier structure in some bond markets and would be meaningless without an explicit commitment from the ECB to go on buying at-risk debt.

"On paper this solution has some merits because it is expedient ... but is in fact fraught with complications that are very likely to make it fail," Shahin Vallee, an analyst with Bruegel, a leading think-tank, said in a research paper.

As well as trying to strengthen the rescue fund, euro zone leaders are racing to convince banks to accept "voluntary" writedowns of up to 50 percent on their Greek sovereign holdings. They are also trying to agree on a blueprint for recapitalizing financial institutions at risk from the deepening crisis.

Greece remains mired in recession and its overall debt is forecast to climb to 357 billion euros ($489 billion) this year, or 162 percent of annual economic output -- which few economists believe can be paid back.

A Reuters polls of economists predicted European leaders will probably ask private investors to shoulder losses of around 50 percent on holdings of Greek government debt, the top end of a range suggested by officials last week.

SPANISH WARNING

Moody's cut Spain's bond rating to A1, from Aa2, the third of the major agencies to act in recent weeks and taking it a notch below the ratings of Standard & Poor's and Fitch.

The agency's reasoning may focus minds ahead of Sunday's summit, highlighting the lack of resolution to the bloc's crisis rather than particular Spanish policy shortcomings.

"Since placing the ratings under review in late July 2011, no credible resolution of the current sovereign debt crisis has emerged and it will in any event take time for confidence in the area's political cohesion and growth prospects to be fully restored," Moody's said.

While Europe's leaders rush to stop a larger writedown of Greek debt infecting others in the euro zone, for ordinary Greeks, the cuts demanded of their country in return for help means several more years of pain.

Black-clad demonstrators hurled stones and fire bombs at police in front of the Greek parliament on Wednesday as tens of thousands rallied for a nationwide general strike to coincide with a vote on painful new austerity measures.

The mood was furious among demonstrators, fed up after repeated doses of austerity and increasingly hostile to both their own political leaders and international lenders demanding ever tougher measures to cut Greece's towering public debt.

"Who are they trying to fool? They won't save us. With these measures the poor become poorer and the rich richer. Well I say: 'No, thank you. I don't want your rescue'," said 50-year public sector worker Akis Papadopoulos.

(Additional reporting by Luke Baker in Brussels, Lefteris Papadimas and Renee Maltezou in Athens, Eva Kuehnen and Edward Taylor in Frankfurt and Elizabeth O'Leary in Madrid; Writing by Mike Peacock, editing by Janet McBride)