The leaders of Germany and France will try to agree Monday on a cohesive plan to help save the euro through stricter oversight of government budgets.
Financial markets signaled optimism that French President Nicolas Sarkozy and German Chancellor Angela Merkel will unveil a unified plan that tightens political and economic cooperation among the 17 European Union countries that use the euro and sets the stage for more aggressive aid from the European Central Bank.
The Merkel-Sarkozy plan will define the agenda for a meeting in Brussels on Friday by the leaders of all 27 EU countries. At stake is the survival of the euro, whose break-up would push Europe and the global financial system into chaos.
European stocks rose Monday, adding to last week's big gains, while the yields on European bonds fell, suggesting stronger demand from investors. Bond yields move inversely to their prices. So when the yields, or interest rates, on government bonds fall, it means investors have a higher level of confidence in being repaid.
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The yield on Italy's ten-year bond dropped 0.40 of a percentage point to 6.16 percent a day after the country's new government agreed a package of austerity and growth measures.
"Christmas may well come early for global markets after this week's meetings," said Shavaz Dhalla, a financial trader at Spreadex.
An agreement on tighter integration between the 17 euro countries would be seen as a crucial first step in resolving the debt crisis that's already seen Greece, Ireland and Portugal bailed out. The European Central Bank has hinted that if governments agree to the closer spending oversight that Merkel is advocating, it could offer more support to financially weak countries. Analysts say that could come in the form of more bond-buying, which has the effect of reducing the borrowing costs of countries.
Merkel and Sarkozy agree on the need for tough limits on how much governments can spend or borrow and on the need to sanction those who don't obey the rules.
However, they appear to disagree on how to achieve the tighter oversight. Merkel wants to change the basic EU treaties, a code of rules that each EU country agrees to bide by as part of the bloc, and for EU governing bodies to check up on states' spending plans. Sarkozy is hesitant to transfer more sovereign power to the EU bureaucracies in Brussels, especially as he faces a tough re-election campaign in April.
On Friday, the Merkel and Sarkozy will present their plan to EU leaders and face counterproposals and negotiations.
Even if there is general agreement Friday on tightening budget controls, the uncertainty for the euro is not over. Changing the EU treaty, for example, could take more than a year. And many economists fear the new rules alone would not be enough to halt the rise in Europe's borrowing costs.
"There is a real danger that anything agreed this week will be watered down as it goes through the process of approval at national levels and what we end up with is less of a fiscal union, more of a strengthened stability pact," said Gary Jenkins, an analyst at Evolution Securities.
The hope is that a commitment by governments to long-term changes in the way they manage their spending will reassure the ECB that it can step up its bond purchases. More help from the ECB would give governments time to reform their economies to improve growth and reduce debt.
Fears that countries as large as Italy and Spain, the eurozone's third- and fourth-largest economies, will not be able to sustain their debt loads has pushed borrowing rates higher in recent months. Their benchmark 10-year borrowing rates in recent weeks rose above the 7 percent threshold that eventually forced Greece, Ireland and Portugal to seek bailouts. By comparison, bond yields in Germany, Europe's largest and most stable economy, are roughly 2 percent.
On Monday, Italy's new Premier Mario Monti will present a package of austerity and growth-boosting measures to a skeptical Parliament. Monti is to brief both Parliament chambers on the package, which includes 30 billion euros ($27 billion) of spending cuts and tax hikes. About 10 billion euros of those savings will be reinvested in the economy to boost growth.
His government agreed Sunday to slap taxes on property and luxury goods, increase the age at which retirees can draw pensions, trim the cost of Italy's political class and give incentives to companies that hire women and young workers.
Italy, whose government debt is equivalent to 120 percent of the country's annual economic output, needs to refinance 200 billion euros ($270 billion) of its 1.9 trillion euros ($2.6 trillion) of outstanding debt by the end of April.
The size of the problems facing Italy and Spain are considered too large for the existing funds available to the European Financial Stability Facility ($590 billion) and the IMF ($389 billion.) To boost the firepower of the IMF, several economists have proposed that the ECB lend to it.
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