EU leaders get ready to engineer fiscal union

The European Central Bank is expected to delve deeper into its toolbox to stimulate bank lending and fight off a recession as Europe's leaders gather to lay the foundations for a fiscal union.

ECB policy makers meeting in Frankfurt will cut the benchmark interest rate by a quarter percentage point to 1 per cent, according to economists in a Bloomberg News survey.

They may also loosen collateral criteria to give banks greater access to cheap cash and offer longer-term loans, said three euro-area officials with knowledge of the deliberations.

Hours later, Europe's leaders will convene in Brussels for talks to frame the fifth "comprehensive" solution in 19 months to a debt crisis that's left Germany and France facing the threat of losing their AAA rating from Standard & Poor's.

The ECB says governments must address the cause of the turmoil as it focuses on getting banks lending again rather than increasing purchases of indebted nations' bonds.

"It's yet another date with destiny in the euro area," said Julian Callow, chief European economist at Barclays Capital in London.

"It's clear there won't be the ultimate resolution, but the proposals are going in the right direction. The markets seem to have finally understood that in the ECB's eyes it's up to governments to solve it, and it's worth noting that it's doing a lot on the banking side." The ECB's insistence that governments take measures to restore investor confidence appears to have paid dividends, with Italian and Spanish yields plunging after Germany and France agreed to move the 17-nation euro area toward a fiscal union.

French President Nicolas Sarkozy and German Chancellor Angela Merkel are proposing to amend European treaties to tighten controls on budgets. In a joint letter to EU President Herman Van Rompuy, the leaders said they want a decision by the close of their summit so that the measures can be ready by March next year.

Still, Germany rejects proposals to combine the region's current and permanent rescue funds, a German government official said in Berlin yesterday.

The ECB had to step up its bond purchases to stamp out the crisis, said Angel Gurria, secretary general of the Organisation for Economic Co-operation and Development.

"The ECB is the ultimate weapon" and "has to be part of the solution", he said yesterday. "You are using a slingshot, where is the bazooka?"

ECB President Mario Draghi said the bond purchases "can only be limited". If governments moved toward a "fiscal compact", there might be room for "other elements", he said, without elaborating.

The OECD said that doubts about the survival of the euro had caused global growth to stall and represented the main risk to the economy. The euro area was already in a "mild" recession.

- Bloomberg