European leaders are negotiating a “grand bargain” to tackle the continent’s debt crisis that would overhaul the eurozone’s €440bn rescue fund in exchange for tough austerity measures and closer oversight of debt-burdened member states.

Officials involved in the intensifying negotiations say the deal could also include a revamp of both the Irish and Greek bail-outs to extend the payment periods or cut the interest rates on their bail-out loans.

Some parts of the package remain highly controversial, and officials warned that a final deal may still be weeks away. No decisions are likely at Friday’s summit of European Union heads of government, but leaders hope to complete the package by the following summit, scheduled for late March.

Among the more controversial elements is the call by some officials, including representatives of the International Monetary Fund, for a Portuguese bail-out to be included in the deal. A smaller group of officials has also urged that a flexible line of credit be offered to Spain.

Those measures are opposed by the European Commission, the EU’s executive, and some within the German government who say that Portugal’s stable banking sector and near-EU-average debt levels may not necessitate a bail-out. There is even more resistance towards assistance for Spain since its recent aggressive moves to shore up its troubled savings banks . Instead, “enhanced surveillance” of Spain and Portugal is being considered. On the fund, there is widespread consensus that it should be able to lend its full €440bn.Currently, to keep its triple A rating, it can lend only about €250bn.

Differences remain on a European deal
European officials have given warning that there are still significant differences to be worked out before a final deal on a “grand bargain” on tackling the debt crisis.

Insiders say Germany wants more austerity measures and intensified economic co-ordination. Proposals include eurozone-wide agreements on retirement ages, corporate taxation and “debt brake” laws.

Broad outlines of the new co-ordination plan will be presented by Angela Merkel, German chancellor, and Nicolas Sarkozy, French president, at Friday’s European Union summit in Brussels. The main elements being considered for the package are:

Overhauling bail-out fund
Leaders have agreed to increase the €440bn ($600bn) bail-out fund’s lending capacity – currently limited to about €250bn because of the need to retain large cash buffers – so it can actually use all €440bn. How this will be achieved remains unsettled.

One Berlin-backed proposal would see triple A rated countries, including Germany, increase loan guarantees while other, less creditworthy countries put up cash.

The European Commission also backs new powers for the fund, including authority to buy bonds of struggling countries on the open market or through loans to debt-burdened governments such as Greece, who would buy back their own bonds as a form of voluntary debt restructuring.

Opposition from the Free Democrats, Ms Merkel’s coalition allies, has thrown agreement on these powers into question.

Ireland and Greece

There is widespread agreement to lengthen payment schedules for Greece’s €110bn bail-out package, which would enable Athens to get over a loan repayment “hump” in 2013.

More controversially, leaders are also deliberating whether to lower interest rates in both Greece and Ireland’s bail-out. The current system requires high rates to discourage countries from seeking rescues.

But some leaders, including Olli Rehn, the EU’s senior economic official, have argued that the political hit taken by Irish and Greek leaders show that governments are reluctant to embrace EU bail-outs, making high interest rates unnecessary.

Deliberations have been complicated by public demands for lower rates from Michael Noonan, expected to be Ireland’s next finance minister: officials are reluctant to change the rates in the face of such public pressure.

Economic co-ordination

The Franco-German plan is for a form of “economic government” at the eurozone level. They suggest that the 17 eurozone countries, as well as others that volunteer, should agree to implement five or six policies to boost competitiveness, including potentially raising qualification ages for state pensions; commitments to bring national corporate tax rates closer together; and “debt brakes” to prevent rampant spending. It remains unclear how this would be achieved but such measures would likely only be taken voluntarily.

German officials have suggested that these measures would be agreed by governments but policed by the European Commission. The Commission has also included similar measures in its new “European Semester”, a six-month review of national budgets that could be a vehicle for the austerity deal.

Spain and Portugal

A group of officials, including some from the International Monetary Fund, have backed pushing Portugal into a bail-out as part of the deal.

The measure has been fiercely resisted by the Portuguese government and other EU officials.

Similarly, a smaller group has backed giving Spain a line of credit, a proposal that has met similar resistance. Instead, there is growing consensus to move towards “enhanced surveillance” of both countries, which would involve having the European Commission scrutinise Spanish and Portuguese reform policies more closely, giving them “stamps of approval” after vetting.

New budget rules

For months, EU officials have been debating new budget rules that would fine eurozone members that do not reduce sovereign debt levels.

Senior European leaders want the new legislation passed by this summer and there is a push to include a detailed agreement on legislative language in the March package.

Differences remain over how automatic the fines would be, but officials say those disagreements have narrowed.

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