European Union leaders will be warned on Thursday that a rolling debt crisis poses a systemic threat to the euro zone as they seek to paper over divisions at a summit on how to restore confidence.

European Commission President Jose Manuel Barroso will tell the 27 leaders that the crisis requires new steps by the whole single currency area and specific measures by member states such as Spain and Portugal to put their finances in order.

The current sovereign crisis has now become systemic in nature, and is driven not only by budgetary fundamentals but also by the mispricing of credit risk by investors and short-term herding behavior in the markets, Barroso will say, according to speaking notes obtained by Reuters.

The two-day EU summit comes as Portugal and Spain face growing bond market pressure after heavily indebted Greece and Ireland received EU/IMF bailouts in return for implementing harsh austerity measures.

Echoing IMF chief Dominique Strauss-Kahn, who has criticized Europe's country-by-country approach as inadequate, Barroso said the crisis required a comprehensive, swift and consistent response.

EU leaders are set to approve a change in their governing treaty to establish a permanent crisis resolution mechanism that would replace the temporary 440 billion euro ($580 billion) financial safety net created in May, which expires in 2013.

The planned European Stability Mechanism would make loans on strict conditions to member states shut out of credit markets, but also provide for private bondholders to share with taxpayers the cost of future debt writedowns on a case-by-case basis.

German Chancellor Angela Merkel, the driving force behind the treaty change, designed to placate Germany's constitutional court, has sought to keep other ideas, such as increasing the size of the rescue fund or issuing euro zone bonds, off the summit agenda.

DISPUTE SETTLED?

Merkel told reporters on arrival for a conservative leaders' pre-summit meeting in Brussels that setting up the stability mechanism was a giant act of solidarity and reaffirmed Germany's commitment to a stable, enduring euro.

The chancellor said earlier she had settled a dispute with Jean-Claude Juncker, who chairs the finance ministers of the euro zone, over his call to issue common euro area bonds, but differences still looked likely to arise at the summit.

Jean-Claude Juncker and I had a long telephone conversation and cleared up the issue a while ago, Merkel said in an interview with Germany's Bild newspaper published on Thursday. With so much at stake, the emotions sometimes get involved.

Merkel says so-called E-bonds would remove the incentive for countries to balance their budgets, and would raise Berlin's borrowing costs. Juncker, who last week called Germany's instant rejection un-European, confirmed he had made peace with Merkel but hinted he might raise the proposal at the summit anyway.

He said he regretted dissonances in public that had given financial markets more cause for concern, and that he was focused on trying to achieve unity at the summit, as well as getting Spain and Portugal to improve their finances.

I know very well that if there is a debate (on euro bonds), there cannot be a decision one way or the other at today's European summit, Juncker told French daily Liberation, vaunting the benefits of common bonds for reinforcing fiscal discipline.

Ratings agency Moody's warned Spain on Wednesday that its debt could be downgraded, saying it was worried about its high debt funding needs, indebted banks and regional finances, although it did not expect Madrid to have to follow Greece and Ireland in seeking an EU bailout.

Spain's Treasury paid a high premium to sell long-term bonds on Thursday but found strong demand, in a test of investors' appetite for euro zone peripheral debt.

Portugal announced extra measures on Wednesday to cut red tape and bolster structurally slow growth, in a move to convince EU officials and financial markets it is doing enough to stave off the pressure to seek EU financial aid.

NO CONCRETE DECISIONS

EU leaders, whose end-of year summit starts at 1500 GMT, are not expected to take new decisions on managing the immediate crisis, an inaction that financial markets could be interpret as a sign of weakness when full-on trading resumes in the new year.

Throughout 2010, EU leaders have struggled to show unity and clear communication in handling the crisis, alternating between rushing out half-formed or contradictory proposals and dithering on the right course of action while markets burned.

Repeated statements of unity at half a dozen summits have sometimes not been followed by action, leaving markets skeptical and piling more pressure on the euro and debt yields.

As well as approving the treaty change, the leaders are expected to discuss how they can improve the current temporary financial safety net, which with a smaller EU community fund and contributions from the International Monetary Fund adds up to a potential 750 billion euros.

One possibility is to increase the money available, while another would involve making it more flexible so that it could provide credit lines before a country is up against the wall.

Belgian Finance Minister Didier Reynders said the EU's portion, 440 billion euros, could potentially be doubled to fend off the threat of renewed market pressure on Portugal and Spain, and Spain has also backed the idea of a larger fund.

Of course we need to show we have deep pockets, Reynders told reporters.

While that may be discussed, EU sources indicate that they do not expect a concrete decision on enlarging the fund.

The European Central Bank holds the second day of a regular, non-rate setting meeting on Thursday, when it is expected to agree to ask euro zone member states for more capital, a move to lower its risk profile as it helps tackle the crisis.

That issue may also be discussed among EU leaders on Thursday, when they will be joined by ECB President Jean-Claude Trichet. The ECB has come under pressure to step up its bond-buying program to help countries struggling to fund themselves in volatile and punitive market conditions.

As well as fears about the debt situation in Portugal and Spain, which has approximately 275 billion euros of sovereign and bank debt expiring in 2011, there are increasing worries about other euro zone member states, including Belgium.

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