26/10/2011 18:16 BST | Updated 26/12/2011 10:12 GMT

Eurozone Crisis: European Leaders Meet Amid Fading Hopes For Real Euro Resolution

Prime Minister David Cameron risked the wrath of French President Nicolas Sarkozy as he arrived in Brussels along with other European leaders in an attempt to solve the eurozone crisis.

The pair clashed at last weekend's summit when Sarkozy reportedly told Cameron he was sick of Britain telling eurozone leaders what to do about the problem while refusing to join the single currency.

Wednesday night's talks take place as markets hold their breath over whether leaders of the European Union and 17 eurozone member states can thrash out the details of a plan to end the ongoing sovereign debt crisis.

In the Commons before leaving for Brussels, Cameron called once again for "decisive" action on Greece, a "proper recapitalisation" of the banks and a "firewall" to prevent contagion spreading.

Earlier, hopes were fading that a European “grand plan” would solve the crisis, amid divisions over key proposals.

Economists, analysts and investors are predicting that tonight’s eurozone summit will end in a broad political statement that, at best, will briefly sate the markets but ultimately not resolve deeper problems within the single currency area.

The bare minimum that the markets are hoping for is clarity over the scale of the “haircut” on Greek debt that investors will have to accept. Initially agreed at 21%, it seems likely that a far higher figure will emerge from the summit. German negotiators are believed to want haircuts of 50-60%. An agreement on a support and new structural reform package would also shore up confidence, at least temporarily.

Alessandro Leipold, chief economist at the Lisbon Council and former acting director of the International Monetary Fund’s European department, said that a cut of that size would effectively mean a form of “unilateral” sovereign default by Greece.

“They’re still kidding themselves when they say that they want that to be voluntary,” he said.

“A default need not be disorderly, but for it to be orderly depends on the international financial community,” he said, noting that continued official financial support to Greece would be needed, however politically difficult that would be. IMF and other international support is normally conditional on recipient countries continuing to pay their creditors.

An announcement on the size and structure of the European Financial Stability Facility (EFSF), the eurozone’s temporary bailout mechanism, could also reassure markets that policymakers have the will and the firepower to tackle both a sovereign default and a much-needed recapitalisation of the banking sector.

The Bundestag, Germany’s parliament, passed a motion on reform to the EFSF earlier in the day, paving the way for it to use financial engineering to increase its deployable capital.

“This is a big thing - where is the money going to come from? It’s all well and good to say we want the banks to raise €100 billion to recapitalise and guard against any new issues, but where that’s going to come from is what we want to know,” James Hughes, senior market analyst at Alpari UK, told the Huffington Post UK earlier in the day. “[The haircuts on Greek debt] are probably the biggest issue… Germany wants 50 or 60% write-downs. That’s going to be tough to agree but pretty much imperative.”

The main European stock markets were flat ahead of the summit, as traders held off taking strong positions amid considerable uncertainty. However, debt markets showed that there were still serious reservations about the ability of Italy and France to pay off their debts.

The Italian government’s failure to agree on austerity measures needed to secure continued support from the ECB in propping up its bonds has led to significant tension both domestically and internationally. Deputies in the Italian parliament clashed first verbally and then physically during a debate this afternoon.

Italy remains one of the largest potential obstacles to formulating a firm plan. The Berlusconi government is struggling with intransigent coalition members and failing to reassure investors that it is capable of reducing its vast debt.

While Berlusconi inevitably stole headlines, the real agency rests with Germany, analysts said. German Chancellor Angela Merkel spoke emotively in the Bundestag about the future of the euro and the importance of the European Union. Her own support for the single currency, and her leadership, will be vital, according to Nieves Perez-Solorzano Borragan, senior lecturer in European Politics
at the University of Bristol.

“The key issue is how strong is Germany as a member state and how strong is Angela Merkel to carry the rest of the member states with her… The commitment of Germany is critical here,” she said

While markets want clarity on technical details – however painful the crystallisation of losses in the banking sector might be – they might be disappointed. Leaks from within the delegations hitting the newswires seem to be managing expectations, rather than promising any real resolution.

Regardless, Leipold said, the simple fact that the main points that are being debated clearly match those expected by the market is in itself a big step forward. He likened the EU to “a friend who has depression and is in denial, and suddenly realises that he has the need to act on it. At least, finally, it’s put denial aside and recognised the problem it has,” he said.

Longer term, the crisis and the tangled response has undermined the legitimacy of the European Union amongst member states and their electorates.

“I think it’s going to affect the European Union, as not being able to provide solutions to economic problems, and some of the legitimacy that the European Union has been able to rely on in the past relied on that – the common market, the free movement of people,” Perez-Solorzano Borragan said.

Leipold echoed this sentiment. “There’s really a tension in Europe between the crisis that is pushing politicians willy nilly towards greater unity or greater centralisation, while at the same time pushing electorates in the opposite direction, or rejection of Europe,” he said.

“You have a political tension there between… [the euro] is essentially a political project at the end of the day, and I don’t know how that tension will be resolved, unless policymakers undertake a pedagogical effort, which they haven’t really done, to explain the advantages of Europe.”

Beyond the immediate crisis response, making the single currency work long term will involve better integration and fiscal discipline amongst member states – bringing them closer to a German model than an Italian one. As Perez-Solorzano Borragan said: “In a way, we seem to be back to the division between northern member states and southern member states.”

Finding a mechanism to close this divide – and prevent countries like Italy from flaunting rules made in Brussels – will be crucial.

Other economies ultimately bowed to pressure and addressed their problems. Italy has so far failed to do so.

Leipold, himself Italian, expressed frustration that the “dysfunctional” Italian government was resisting market pressure to reform, saying that “the Italian situation is quite critical.

“If you look at other countries, market pressure at the end of the day, rather than peer pressure, always works,” Leipold said. “The Spaniards took perhaps a little too long, but in the end did what they needed to do, and had a political horizon that enabled them to do it with a fairly large majority, and did so with some bipartisan support. It happened in Portugal as well, and a similar situation in Ireland… If market pressure is exercised then countries do what is needed – Italy is seemingly the exception.”