European finance officials are working on urgent measures to ease financial market pressure on Spain and Italy
Meanwhile, EU leaders began a summit on Thursday deeply divided over how to resolve the eurozone's debt crisis.
French President Francois Hollande said on arriving at his first full EU summit after six weeks in office that he expected agreement on emergency steps to help eurozone partners whose borrowing costs had reached unsustainable levels.
"I have come here to get very rapid solutions to support countries in the greatest difficulty on the markets even though they have made considerable efforts to restore their public finances," Hollande told reporters.
Three EU sources said work was focused on using the eurozone's temporary EFSF rescue fund and a future permanent ESM bailout fund to buy new Spanish and Italian bonds as they were issued to underpin their bond auctions.
Rome and Madrid have been pleading for help but have received a cool response from Berlin and other capitals.
The funds will have a maximum firepower of €500-billion once the ESM is fully stocked in 2013, minus €100-billion already earmarked to aid Spanish banks.
The sources said an agreement could be clinched at a meeting of the 17 eurozone leaders on Friday after the regular 27-nation EU summit ends.
"We've got to look at existing instruments, and both the EFSF and the ESM, once it is active, have the capacity to buy bonds in the primary market. That's the area that makes sense to operate on," one official said.
Requesting assistance
Italy and Spain would still have to request assistance, which they have been loath to do, and would be subject to fiscal policy conditions and international monitoring. But they might not be required to do more in austerity and structural reforms than they have already undertaken, the sources said.
Dutch Prime Minister Mark Rutte, leader of one of the most hard-line north European creditor countries, said the eurozone could use its existing tools to solve the market problem.
It was the 20th EU summit since the still-widening eurozone sovereign debt crisis began in early 2010 after Greece disclosed its public deficit was far higher than previously reported.
Financial analysts and political leaders played down any prospect of a rapid solution to the turmoil which has forced Greece, Ireland, Portugal and now Spain and Cyprus to seek international bailouts.
Reflecting public anxiety about the future of the single currency, European Parliament President Martin Schulz told the summit: "Today, people throughout Europe are casting worried eyes towards Brussels, towards this summit meeting, because they fear that our European project is one step away from disaster."
Positions were so far apart that even before Thursday's meeting began EU sources said there was the prospect of another summit in July to try to bridge the differences.
Merkel is being urged at home to hang tough and reject all efforts to make Germany underwrite European borrowing or banks, which some of her partners say that may be the only way to save the single currency.
Emergency action
"Nein! No! Non!" shouted a headline splashed across the front page of the normally sober German business daily Handelsblatt, with a commentary by its editor-in-chief saying Merkel must remain firm at the two-day summit.
Spain and Italy are pleading for emergency action to bring down their spiralling borrowing costs before they are forced out of the bond market. They want the eurozone's rescue funds or the European Central Bank to intervene fast.
Italian Prime Minister Mario Monti is also under mounting domestic pressure to achieve results or risk seeing his technocratic government fall within a few months as the centre-right and centre-left parties that support him jockey for position before an election due in 2013.
A senior German government source, briefing reporters in Berlin before the summit, played down the leap in Spanish and Italian borrowing costs.
"We would warn against exaggerated panic-making," he said.
European Council President Herman Van Rompuy and European Commission President Jose Manuel Barroso have set long-term goals of creating a eurozone treasury to issue joint bonds in the medium-term, and establishing a banking union with central supervision, a joint deposit guarantee and a resolution fund.
Merkel insists that fundamental reforms to give European Union authorities power to override national budget and economic policies must come before any further shared liability.
Export boom
Germany has enjoyed an export boom even as the crisis has spread, removing any sense of urgency among voters for radical steps to support other countries. The economic pain is only just starting to affect Germans, with growth slowing and unemployment creeping up in June.
"It's crucial for us to avoid taking measures that would ease pressure on southern Europe to reform. That is why I seriously question a rapid transition to a banking union, or eurobonds," Dutch premier Rutte told his Parliament. "That would result in a sort of 'paracetemol effect' for southern Europe, like the effect performance enhancers have on athletes."
The euro hit a three-week low and world stocks fell as investors bet that this latest summit would fail to produce concrete measures to tackle the crisis, sending 10-year Spanish government bond yields above the danger level of 7%.
Italy had to pay its highest yield since December of 6.19% to sell 10-year debt on Thursday, helped by domestic demand and a smaller-than-average sale.
Many international investors have deserted Spanish and Italian debt, pushing yields to levels that Madrid at least cannot afford for long as it tries to save banks ravaged by a property market collapse and rein in an overshooting deficit.
Merkel has previously dismissed pleas from Rome and Madrid for rapid measures to support their bonds.
France's Hollande advocates joint "eurobonds", which would bring down borrowing costs for the weak because the pool of guarantors would include the strongest – principally Germany.
Narrowing differences
Germany, by contrast, does not want to use its credit rating to support others unless they share control of tax and spending powers first. Hollande and Merkel met in Paris on Wednesday evening to try to narrow their differences.
While they agreed on a package of measures to promote growth trumpeted as being worth €130-billion – the first item on Thursday's summit agenda – there was little sign of a meeting of minds on the thornier crisis-resolution issues.
Austrian Chancellor Werner Faymann said the 17-nation currency bloc's permanent rescue fund, the European Stability Mechanism (ESM), due to start operating next month, should be turned into a bank and allowed to borrow from the ECB, which could quadruple its €500-billion war chest.
That backed proposals by Monti to leverage up the rescue funds to underpin troubled countries' bonds. But ECB chief economist Peter Praet said he was "very sceptical" of Monti's idea, which would greatly increase the central bank's exposure.
Speaking in parliament on Wednesday, Merkel said she considered joint euro bonds and bank deposit guarantees illegal, economically wrong and politically counterproductive.
Finnish Europe Minister Alex Stubb told Reuters that Europe should prepared to live in a state of crisis for the rest of the decade. But he said a stronger and more resilient continent would eventually emerge.
"It is an existential crisis, but it's probably the best crisis we've had. It's forcing European leaders to take very difficult decisions and as we all know very few difficult decisions have been taken in a relaxed atmosphere," he said. – Reuters