EU Leaders to Agree on Permanent Bailout Fund

(Reuters) -- EU leaders will sign off on a permanent rescue fund for the euro zone at a summit in Brussels Monday and are expected to agree on a balanced budget rule in national legislation, with unresolved problems in Greece casting a shadow on the discussions.

The summit - the 17th in two years as the EU battles to resolve its sovereign debt problems - is supposed to focus on creating jobs and growth, with leaders looking to shift the narrative away from politically unpopular budget austerity.

The summit is expected to announce that up to 20 billion euros ($26.4 billion) of unused funds from the EU's 2007-2013 budget will be redirected toward job creation, especially among the young, and will commit to freeing up bank lending to small- and medium-sized companies.

But discussions over the permanent rescue fund, a new 'fiscal treaty' and Greece will dominate the talks.

Negotiations between the Greek government and private bondholders over the restructuring of 200 billion euros of Greek debt made progress over the weekend, but are not expected to conclude before the summit begins at 9:00 a.m. EST.

Until there is a deal between Greece and its private bondholders, EU leaders cannot move forward with a second, 130 billion euro rescue program for Athens, which they originally agreed to at a summit last October.

Instead, they will sign a treaty creating the European Stability Mechanism, a 500-billion-euro permanent bailout fund that is due to become operational in July, a year earlier than first planned. And they are likely to agree the terms of a 'fiscal treaty' tightening budget rules for those that sign up.

PERMANENT RESCUE FUND

The ESM will replace the European Financial Stability Facility, a temporary fund that has been used to bail out Ireland and Portugal and will help in the second Greek package.

Leaders hope the ESM will boost defenses against the debt crisis, but many - including Italian premier Mario Monti, IMF chief Christine Lagarde and U.S. Treasury Secretary Timothy Geithner - say it will only do so if its resources are combined with what remains in the EFSF, creating a super-fund of 750 billion euros ($1 trillion).

The International Monetary Fund says an agreement to increase the size of the euro zone 'firewall' will convince others to contribute more resources to the IMF, boosting its crisis-fighting abilities and improving market sentiment.

But Germany is opposed to such a step.

Chancellor Angela Merkel has said she will not discuss the issue of the ESM/EFSF's ceiling until leaders meet for their next summit in March. In the meantime, financial markets will continue to fret that there may not be sufficient rescue funds available to help the likes of Italy and Spain if they run into renewed debt funding problems.

There are certainly signals that Germany is willing to consider it and it is rather geared toward March from the German side, a senior euro zone official said.

The sticking point is German public opinion which is tired of bailing out the euro zone's financially less prudent. Instead, Merkel wants to see the EU - except Britain, which has rejected any such move - sign up to the fiscal treaty, including a balanced budget rule written into constitutions. Once that is done, the discussion about a bigger rescue fund can take place.

After nearly three years of crisis, some economists believe the combination of tighter budget rules, a bigger bailout fund and a commitment to broader structural reforms to boost EU productivity could help the region weather the storm.

The fiscal compact and the ESM will shape a better future, said Carsten Brzeski, a euro zone economist at ING.

Combined with ongoing austerity measures and structural reforms in peripheral countries, and, of course, with a lot of ECB action, the euro zone could master this stage of the crisis.

Economists say the pivotal act in recent months was the European Central Bank's flooding of the banking sector with cheap three-year money, a measure it will repeat next month.

GREEK DEAL?

While EU leaders are managing to put together pieces of legislation and financial barriers that might help them stave off a repeat of the debt crisis, immediate concerns - especially over Greece and potentially Portugal - remain.

By far the most pressing worry is the seven-month-long negotiation over private sector involvement in the second Greek rescue package. A deal in the coming days may help restore investor confidence, although Greece will still struggle to reduce its debts to 120 percent of GDP by 2020 as planned.

If there is a deal, the heads of state and government can endorse it, welcome it and say that now it is up to Greece to agree to and deliver on reforms to get the second financing package, the euro zone official said.

Negotiators believe they have until mid-February to strike a deal. Failure to do so by then would likely force Greece to miss a 14.5 billion euro repayment on its debt due in mid-March.

Even if Athens can strike a deal with private bondholders to accept a 50 percent writedown on the nominal value of their bonds, it may still not be enough to close Greece's funding gap.

The IMF has suggested it may be necessary for public sector holders of Greek bonds - including the ECB and national central banks in the euro zone - to write off some of their holdings in order to close the gap.

Such a move would not necessarily involve the ECB or national central banks incurring losses, they would just be expected to forego any profit on the bonds they have bought.

But German ECB board member Joerg Asmussen told Reuters there was no possibility of the ECB taking part in the private-sector restructuring of Greece's debt.

(Reporting By Jan Strupczewski, editing by Mike Peacock)