Paul Taylor: Eurozone bailout terms squeezed in Merkel's 'corset'

Berlin's centre-right coalition parties and the German central bank have taken hardline positions that could tie Chancellor Angela Merkel's hands against any strengthening of the eurozone rescue fund, dashing market expectations.

"Markets are beginning to smell there is huge room for disappointment on the outcome of the euro summit … as there will be several regional elections in Germany," one London bond trader said.

A parliamentary resolution drafted by the three German coalition parties would sweep most of the potential solutions off the table. Although not legally binding, it will put Ms Merkel in a tight negotiating "corset", as Christian Democrat Klaus-Peter Willsch put it.

For weeks, EU officials and diplomats have been working on options to ease the terms on bailout loans to Ireland and Greece, increase the effective lending capacity of the European Financial Stability Facility (EFSF) and let it buy eurozone sovereign bonds or fund buybacks by highly indebted countries.

In a "comprehensive package" deal set to be finalised at the summit on 24-25 March, members of the 17-nation eurozone would accept, in return for much tighter budget discipline, tougher bank stress tests and a series of economic reforms designed to increase their competitiveness.

But if Ms Merkel abides by the coalition resolution, she will be able to offer little more than an extension of the maturities on Greek rescue loans in exchange in the short-term, plus agreement to a heavily constrained €500 billion (430bn) permanent rescue fund from 2013.

Specifically, the resolution seeks to rule out "jointly financed or guaranteed purchase programmes of government debt" for reasons of constitutional and European law and on economic grounds. It also opposes lending member states money to buy back their own bonds in the market.

Ms Merkel has said, with 26 other EU partners, she wouldn't be able to achieve 100 per cent of Germany's goals. But a parliamentary source said MPs gave finance minister Wolfgang Schaeuble a rough ride when he told them in a closed-door meeting that preserving the stability of the eurozone might cost Germany a little bit more.

Bundesbank president Axel Weber has warned against cutting the punitive interest rates on eurozone bailouts."The existing instruments for short-term crisis management are adequate and, despite repeated demands to the contrary, should not undergo significant adjustment," he said.

A European Union official involved in the talks said this would make any move to reduce the Greek debt burden extremely difficult.

If investors find the summit outcome unconvincing, they may stage another sell-off of eurozone sovereign debt, pushing Portugal over a cliff and pressurising Spain, Belgium and Italy. Portugal's cost of borrowing has already soared this year and pressure on Greece to default on a debt mountain set to reach nearly 160 per cent of output in 2013 is also likely to increase if Germany closes the door to most of the proposed debt relief measures.

Spanish premier Jos Zapatero said earlier this week he was confident Germany would support a strengthening of the eurozone fund despite Ms Merkel's domestic problems.

Yet the hard German line has support from north European allies. Dutch finance minister Jan Kees de Jager has opposed debt buybacks or a reduced interest rate for Greece.

A senior eurozone source suggested momentum for an increase in bailout capacity was waning. The Netherlands, Austria and Finland agree with Germany that the EFSF has sufficient funds, even with credit guarantees that reduce its effective lending capacity to €250bn, to handle a potential bailout of Portugal.

Spain appears to be convincing markets it is doing enough to sort its finances. The eurozone source said that eased pressure to raise bailout capacity, but only if eurozone leaders declared they would do whatever is necessary if the situation changes. That could set up a risky game of chicken with markets, which the EU already lost twice last year.