German Chancellor Angela Merkel returns to the front line of theEuropean debt crisis this week as the bloc's leaders squabble overmeasures including bond purchases to relieve concerns the singlecurrency may fragment.

Merkel ends her summer vacation to oversee a Cabinet meetingAug. 15 before departing for Canada and talks with Prime MinisterStephen Harper as the spiraling crisis threatens the globaleconomy. With policy makers awaiting a German high court decisionon bailout funding next month, they're struggling to smoothdivisions over a European Central Bank plan to buy the bonds ofindebted nations.

“It makes no sense for the ECB to start financing” Spain andItaly, ECB Governing Council member Luc Coene said in an interviewwith Belgian newspapers De Tijd and L'Echo published on Aug. 11.“It would only lead to the ECB taking on the whole public debt ofSpain and Italy onto its balance sheet.”

ECB President Mario Draghi said earlier this month the centralbank could purchase sovereign debt alongside euro-area bailoutfunds. While the plan offered Europe an initial respite from theturmoil, Spanish and Italian yields climbed last week on concernthat a debt-purchasing program won't be sufficient to curb thecrisis. Concern over the euro may weigh on already flagging globalgrowth, a prospect underscored today by waning growth in Japan'seconomy.

“The chancellor is like everybody else returning from vacation —you enjoy a different kind of rhythm while on vacation —nevertheless she is returning to work very happily,” SteffenSeibert, Merkel's chief spokesman, told reporters at a regulargovernment press conference in Berlin today. “There will be a lotto do, a lot of energy, which you'll see in the coming days andweeks.”

Italy's 10-year bonds advanced, with the rate slipping 5 basispoints to 5.84 percent as of 12:56 p.m. in Berlin, after it soldits maximum target at an auction of one-year bills. Yields onequivalent Spanish debt dropped 9 basis points to 6.79 percent. Theeuro traded at $1.2339, up 0.4 percent.

While the ECB said that it would undertake bond purchases onlyif troubled nations promise measures to improve their economichealth, Italy and Spain have yet to decide whether they willrequest help.

'Formidable Challenge'

“To ensure that such interventions help to bring down bondyields in a lasting way, they will only be available for memberstates that pursue sound budgetary policies, adopt structuralreforms for growth, and address macroeconomic imbalances,” EuropeanEconomic and Monetary Affairs Commissioner Olli Rehn said in anop-ed published in the Wall Street Journal today, withoutspecifying any nation by name. Those states face a “formidablechallenge,” with “little breathing space to adopt the game-changingreforms that are essential for long-term gain.”

Coene, who also heads Belgium's central bank, told the twonewspapers that ECB officials are divided on what conditions shouldbe agreed. The central bank's experience a year ago demonstrateswhy the ECB is reluctant to step in, he said.

“We haven't forgotten what happened in August of last year: Webought Italian bonds and right after that the Italian governmentreneged on its pledges,” Coene was quoted as saying. “Theconclusion is clear: When you take away the market pressure, youtake away the pressure on politicians to act.”

ECB purchases won't return investor confidence in Spain andItaly, he said, attributing the rise in bond yields to a lack oftrust in those countries to repair their economies.

“Every board member, including the Spanish and Italian ones,knows that our actions will have a short-lived effect” and thatmarket turmoil “will stop only when there's no more Spanish andItalian bonds in the market,” Coene said.

Italian bond spreads need to retreat by the end of the year toavoid “strong” contagion to the economy, said Fabrizio Viola, chiefexecutive officer of Italy's Banca Monte dei Paschi di Siena SpA,La Repubblica reported on Aug. 11. He urged the ECB and theregion's bailout funds to buy sovereign debt on the primary andsecondary markets, the newspaper said.

The euro's permanent rescue fund, the 500 billion-euro ($614billion) European Stability Mechanism, won't become active untilGermany's Federal Constitutional Court rules on its viability onSept. 12. Only with a court endorsement will the German governmentbe able to ratify the ESM treaty.

German Conditions

“It is not our base case that the constitutional court willblock the ESM, though it will likely be a close decision,” JoachimFels, chief economist at Morgan Stanley in London, wrote in a noteto clients yesterday. Still, the judges “could well attachconditions that will make it difficult for the government to makefurther integration steps.”

The possibility that Germany's high court will demand greaterelector participation in euro decisions raised the prospect of areferendum in the euro area's biggest economy, placing thecountry's commitment to the currency in the hands of voters at timethat polls show rising discontent with the costs of the crisis.

While Merkel has resisted the notion of a referendum, hercoalition partners said last week that Germany's role in the crisismight need to be put to a vote. The court's decision may trigger anautomatic referendum if the judges rule that the ESM and thetransfer of sovereign rights require constitutional change, HansMichelbach, a Merkel ally from the Bavarian Christian Social Union,said in an interview on Aug. 10.

The month-long wait for the ESM decision will be paralleled byanticipation on whether Greece continues to receive euro rescuefunds. Greece's troika of international creditors — the ECB, theEuropean Commission and the International Monetary Fund — willreturn to Athens in early September to resume talks as Greek PrimeMinister Antonis Samaras seeks to hammer out 11.5 billion euros inbudget cuts for 2013 and 2014.

Greece's economy contracted for a ninth straight quarter,declining 6.2 percent in the second three-month period of this yearfrom the same period last year, the Hellenic Statistical Authoritysaid today. That makes it harder for the government to meet thebudget-reduction targets required.

“The problems of the euro area continue with no obvious end insight,” Bank of England Governor Mervyn King said in the Mail onSunday newspaper yesterday.

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