European leaders will this week seek to revamp their debtcrisis-fighting strategy and snap a deadlock that is spookinginvestors and prompting warnings of contagion from theInternational Monetary Fund.

With European Central Bank President Jean-Claude Trichetreiterating opposition to any Greek debt restructuring, governmentchiefs convene July 21 in Brussels to discuss “the financialstability of the euro area as a whole and the future financing ofthe Greek program,” European Union President Herman van Rompuy saidin a July 15 statement. Among topics for the talks is a potentialoverhaul of the 440-billion euro ($618 billion) rescue fund toenable Greece to better pay its bills.

The second summit in a month follows an intensification of thedebt crisis that thrust Italy to the attention of investors andpushed bond yields to euro-area records across Europe's mostdebt-laden nations. Delay in finding a solution combined withdiscord among policy makers on whether bondholders should share theburden if Greece defaults has unnerved financial markets.

“This crisis has clearly taken on more systemic risk,” saidLaurent Bilke, head of interest rates strategy for Europe at NomuraInternational Plc in London and a former European Central Bankeconomist. “It's crucial at the current juncture for policy makersto get the right things done.”

Italian Yields Surge
Italian and Spanishbonds fell today, widening the gap in yields versus German bunds asthe crisis spurred investor demand for the euro area's safestassets. The cost of insuring against default on European sovereigndebt, including bonds sold by Greece, Ireland, Italy, Portugal andFrance, rose to records. Last week, Italian two-year note yieldssurged the most in over a year and yields on notes from Ireland,Portugal and Greece soared to euro-era records.

A summit was originally mulled for last week before beingpostponed amid German fears it would backfire without a pact on howthe private sector can bear some of Greece's euro debt burden. Thisweek's meeting takes place just over a year since leaders organizeda 110-billion euro lifeline for Greece.

German Chancellor Angela Merkel will attend the July 21 EUsummit, her chief spokesman Steffen Seibert told reporters today inBerlin.

“I'll only travel there if there is an outcome,” Merkel said inan ARD television interview yesterday. “I do think it's urgentlynecessary. We have to send a signal of stability and I believe wecould make a lot of progress on the Greek program.”

Separately, German Finance Ministry spokesman Martin Kotthaussaid EU finance ministers won't convene ahead of the summit.

Lower Interest Rates
EU leaders are takingcontrol after European finance ministers last week said they would“shortly” deliver fresh measures to cut Greece's debt burden withbond buybacks or a temporary default among the steps being debated.They indicated Greece might be granted lower interest rates andlonger repayment times for official loans, though maybe requiringcollateral.

The tension lies in how to include investors in any secondbailout, which may total as much as 115 billion euros over threeyears. Bankers and officials held talks in Rome last week afterproposals for a “voluntary” rollover of Greek debt met withwarnings from credit-rating companies that they would declare adefault. That would be a bridge too far for the ECB.

“If a country defaults, we can no longer accept as normaleligible collateral defaulted bonds issued by the government ofthat country,” Trichet said in an interview with the FinancialTimes Deutschland released yesterday by the ECB. “This would impairour ability to be an anchor of confidence and stability.”

ECB's Wrath
Germany's government says noextra aid is possible without bondholders being forced to stayexposed to Greek debt. It has incurred the ECB's wrath by pushingfor a debt swap.

“The more we get private investors voluntarily involved now, theless likely we will have to take further steps,” Merkel said in herARD television interview. “Of course we have to be prepared, butthe most important thing is that Greece has to do its homework andprivate creditors are brought into the fold.”

Yields on 10-year Italian bonds increased 11 basis points todayto 5.87 percent as of 10:24 a.m. in London, widening the spread, oryield gap, over benchmark German bunds to 326 basis points. Spanish10-year yields rose 15 basis points to 6.22 percent, taking thespread over bunds to 363 basis points.

The Institute of International Finance, a trade associationrepresenting more than 400 banks and insurers, said in a statementyesterday that “progress has been made and the discussions arecontinuing” after last week's talks in Rome.

Bond Purchases
Also overshadowing thesummit is the question of how far governments will increase thescope of the European Financial Stability Facility given some stepsmay require the support of local legislatures, which would taketime and political capital. It may be allowed to buy bonds in thesecondary market or enable Greece to retire its debt at a discountof as much as 50 percent. Germany has resisted such steps in thepast.

ECB Executive Board member Lorenzo Bini Smaghi said in aninterview with Greece's To Vima newspaper that it would be “useful”to allow the EFSF to buy bonds on the open market, according to atranscript from the ECB published yesterday.

“This would allow the private sector to sell bonds at theirmarket value, which is currently lower than the nominal value,”Bini Smaghi said. “This would allow the private sector to sellwhile the public sector would save money.”

IMF's Share
Officials are concerned theIMF may curb its share of a second rescue unless the plan includesdeep cuts in Greece's debt, two people with knowledge of the talkssaid last week.

The IMF, which has provided one-third of the three previous eurobailouts, last week called for a “greater sense of urgency” infixing Greece given that the 21-month crisis threatens “marketdisorder that would affect funding rates for other vulnerablesovereigns and could have severe implications for financialinstitutions.”

Markets found some calm at the end of last week as Italian PrimeMinister Silvio Berlusconi survived confidence votes on a40-billion euro austerity package that aims to balance the budgetby 2014.

The euro area's banks may also be in focus this week, aftereight lenders failed the European Banking Authority's stress testsreleased on July 15, showing a combined shortfall of 2.5 billioneuros. As many as 16 more will need to bolster capital after theircore Tier 1 ratio dropped below 6 percent, little more than theassessment's 5 percent pass-mark, the EBA said.

Bloomberg News

Copyright 2018 Bloomberg. All rightsreserved. This material may not be published, broadcast, rewritten,or redistributed.