Prospects for a long-awaited breakthrough deal to stem the worsening euro-zone debt crisis were up in the air on Tuesday, as governments and banks remained at loggerheads over how much pain to inflict on holders of government bonds issued by Greece, the country at the heart of the Continent's financial mess.
National governments and banks have been talking for more than a week in an effort to reach an accord on reducing Greece's debt burden, so that the agreement can be included in a planned "comprehensive package" that euro-zone leaders hope to announce at a summit Wednesday in Brussels.
Banks on Tuesday were rebuffing pressure from governments for "voluntary" write-downs of 50% to 60% on their Greek bonds, according to people familiar with the matter, although some said there had been movement that suggested a compromise in time for the summit couldn't be ruled out.
An EU finance ministers' meeting set for Wednesday ahead of the summit was canceled Tuesday, adding to doubts over the package.
Without an agreement on how Greece's debt will be restructured, it will be tough for European leaders to determine the future size of their beefed-up bailout fund, the European Financial Stability Facility.
The leaders are set to boost the fund to offer investors comfort that the initial losses in the event of any default on, say, Italian and Spanish bonds will be met by the facility. They hope this will bring down the two countries' borrowing costs. But how many such bonds will be covered depends in part on how much money is left in the fund after Greece's needs have been addressed, and on how much money the fund will need to pump into the region's shakier banks. A decision on how much European banks will need to add to their capital buffers—the third element of the interlocking package—won't be credible either until their write-downs on Greek bonds are known.
In a further threat to a credible deal, Germany's main political parties are seeking to put pressure on the European Central Bank to stop the ECB's purchases of Italian and Spanish bonds. The German government has agreed to submit the latest proposal for strengthening the euro zone's bailout fund to the Bundestag, the lower house of parliament.
It is due to vote on the proposal Wednesday before German Chancellor Angela Merkel flies to Brussels for the summit.
A draft of the Bundestag resolution, negotiated between the ruling coalition and main opposition parties, says the ECB should stop buying government bonds once the EFSF is able to do so.
"Once the EFSF comes into force, the need for continuing the European Central Bank's secondary-market program falls away," the document says.
Many economists say the ECB's emergency purchases of Italian and Spanish bonds since August are the only thing that has prevented panicked investors from fleeing two of Europe's biggest government-bond markets. Without ECB support, both countries would face unaffordably high borrowing costs.
However, many analysts say they doubt the proposed strengthening of the EFSF would be effective enough for the fund to replace the ECB as the lender of last resort to Italy and Spain.
A Bundestag resolution wouldn't bind the politically independent ECB. But it would highlight the unease about the ECB's bond-buying in Germany, Europe's most important economy, where politicians and voters widely believe that central banks shouldn't finance government debt.
In contrast, other European governments—led by France—want to press the ECB to continue buying bonds.
Ms. Merkel said on Tuesday that she wants to delete such a call from the draft European summit statement, on the grounds that governments shouldn't tell the independent ECB what to do.
Greece appears to be the near-term key for avoiding further financial turmoil.
Without substantial debt forgiveness by banks, Greece will need further massive infusions of European taxpayers' money to avoid a messy insolvency in the short to medium term.
Euro-zone governments agreed in July to lend Greece €109 billion ($152 billion), in the second bailout deal for the country in a year. Germany is insisting that those new loans for Greece total "not much more than" €109 billion, according to a senior Berlin official.
But euro-zone officials worry that their negotiating position vis-à-vis major international banks is weak because the banks know Europe doesn't want to let Greece go bust. That is allowing banks to haggle for smaller losses on their Greek bonds than governments are seeking, in the confidence that governments are likely to keep Greece afloat with additional bailout loans.
The euro zone has already disappointed markets by failing to reach a hoped-for deal at a summit this past weekend, when Ms. Merkel and French President Nicolas Sarkozy said a second summit on Wednesday would be needed.
Failure to agree on specifics on Wednesday would strengthen doubts about Europe's capacity to solve the crisis at all.
"The idea is to have a global package tomorrow [Wednesday]. Obviously if we don't have one, we will have to have another meeting," said a euro-zone official.
The final deadline for unveiling a fully fleshed-out deal, if euro-zone leaders are to salvage credibility, would be the summit of the Group of 20 industrial and developing economies in Cannes, France, on Nov. 3-4.
Italy, meanwhile, is seeking to appease European pressure to accelerate the pace of its economic reforms and to announce a plan Wednesday. Prime Minister Silvio Berlusconi held talks Tuesday with members of his ruling center-right coalition after a cabinet meeting late Monday failed to come up with concrete measures.
The coalition discussed new steps to cut public debt and increase economic growth, including gradually raising Italy's retirement age while reducing some pension entitlements, greater efforts to fight tax evasion, and limited deregulation of parts of the economy. A spokeswoman for Umberto Bossi, leader of the Northern League, one of Mr. Berlusconi's coalition partners, confirmed that the government has reached a compromise on the key pension reform. She didn't elaborate.
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