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EU faces two tough months of bargaining to boost euro confidence

By Paul Taylor

PARIS (Reuters) - European Union leaders face two months of tough bargaining on money, power and the future governance of the euro zone before they can boost confidence that the existential threat to the single currency has faded.

The European Central Bank's pledge to buy the bonds of struggling euro zone countries in unlimited amounts has changed the terms of Europe's debt crisis.

Yet French President Francois Hollande may have been a little premature in declaring a turning point last week after another night of summit negotiation yielded a deal for a euro zone banking regulator to be launched next year.

"We are on track to solve the problems that for too long have been paralyzing the euro zone and made it vulnerable," said Hollande. "I again have confirmation that the worst is behind us."

More nights of horse-trading lie ahead between now and mid-December in which EU states must agree on a common budget for the next seven years, closer fiscal union with more intrusive central supervision of national budgets and a possible separate budget for the euro zone, and more support for the most vulnerable euro states.

They will need to decide how to keep Greece afloat if, as expected, it reaches a deal with international creditors to avoid bankruptcy next month in exchange for more drastic spending cuts and structural reforms.

And they may face months of uncertainty over whether Spain, which has already been promised up to 100 billion euros in loans to recapitalize its ailing banks, can avoid a sovereign bailout.

Above all, the euro zone is a long way from returning to the levels of economic growth needed to make its debts more manageable and get millions of angry unemployed back to work.

For now, the financial market turmoil that threatened the very survival of the currency area a few months ago has abated, at the risk of lulling EU leaders back into complacency over what remains to be done.

The European Central Bank removed that acute sense of crisis by agreeing to buy unlimited quantities of short-term bonds of troubled euro zone countries that apply for a rescue program and accept strict conditions.

"The state of urgency we had over the summer is just not there to the same degree," said a senior EU official who has been present at every night of summitry since the crisis began in late 2009.

"There is not the same sense of having our backs to the wall," he said. "One should know from the way politics works in the European Union that you need a certain sense of crisis to act -- that's the way it works."

BIG THREE TIES AT LOW EBB

Complicating the next few weeks of negotiation, relations among Europe's three leading powers - Germany, France and Britain - are as difficult as at any time for a decade.

The collapse of a proposed aerospace mega-merger between European Airbus manufacturer EADS and British defense company BAE Systems over government stakes underscored the depth of mistrust between Paris, Berlin and London.

Within the euro zone, Germany and France remain at odds over the balance between central EU control of national budgets and economic reforms, and mutualising risks and liability for each others' debts and bank deposits.

Hollande argues Germany must first take steps he sees as vital to underpin vulnerable countries' government borrowing and financial institutions before France will agree to yield more sovereignty to Brussels over its fiscal and economic policy.

German Chancellor Angela Merkel seems determined to avoid any new liability for German taxpayers which would require her to seek approval from her increasingly reluctant parliament before a September 2013 general election.

That may explain why she insisted that euro zone rescue funds could not recapitalize any bank until a euro zone banking supervisor is fully operational late next year, and there would be no retroactive direct recapitalization of banks.

Her stance was a blow to Spain's hopes of getting the cost of rescuing banks hit by the collapse of a real estate bubble off the state's balance sheet, and hence easing its debt burden without recourse to a euro zone bailout. It was also a setback for Ireland's hopes of shedding some of its bank-induced debt.

It remains to be seen whether Merkel's refusal to share such "legacy" costs is Germany's last word, or whether a future Berlin government may revisit the issue after the election.

Many economists believe that a fresh start for the euro zone will require action such as common euro zone bonds or at least a reduction in peripheral members' "legacy" debts to be viable in the long run. Early relief for Madrid appears ruled out, although Merkel said on Sunday Ireland was a "special case".

Yet German officials say relations between Merkel and Hollande are not as tense as they seem in public, and they are confident that he will accept trade-offs between greater European solidarity and more pooling of fiscal sovereignty.

BRITAIN DRIFTING AWAY?

While the rest of Europe is negotiating intensively on closer integration, Britain is talking increasingly about loosening its ties with the EU, and some influential members of the governing Conservative party of leaving completely.

Prime Minister David Cameron has threatened to veto the seven-year EU budget due to be agreed at a November 22-23 summit if spending is not cut. And he wants to exploit the negotiations on closer euro zone integration as an opportunity to negotiate looser membership terms for Britain in the Union.

It remains to be seen how far other European partners are prepared to accommodate British exceptionalism. Finland's Europe minister said last week that Britain seemed to be waving "bye, bye" to the EU, and there was little others could do about it.

The main achievement of the latest summit was to keep plans for a single European banking supervisor broadly on track despite a rearguard battle led by Germany's finance minister.

"I struggle to find any major piece of reform involving more than a couple of countries which has moved from idea to implementation as fast as the European banking union," said UniCredit global chief economist Erik Nielsen.

The most encouraging news for the future of the euro zone, Nielsen said, was the way that Germany's leadership has changed its attitude towards keeping Greece in the euro area, and hence supporting peripheral states in difficulty.

"There is no turning back now, not only because of the already clear signals from the government leadership, but because the political challenge (from the opposition Social Democrats) - impressively - turns out to be coming from a demand for more Europe, and more support for Greece," he said.

(Additional reporting by Luke Baker in Brussels and Andreas Rinke and Noah Barkin in Berlin; Writing by Paul Taylor; editing by Jason Webb)

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