European Union leaders will discuss strengthening the euro zone's 440 billion euro bailout fund at a summit on Friday and try to agree how best to insulate the region from the year-long debt crisis.

Germany and France will set out proposals for tighter economic and fiscal coordination, measures they hope will be included in a comprehensive package that leaders will agree in March, along with changes to the European Financial Stability Facility, the bailout fund agreed last May.

We will talk about how to prepare decisions that are still necessary, in particular with regard to the permanent crisis mechanism which is to be agreed by March, German Chancellor Angela Merkel told reporters as she arrived for the meeting.

In draft conclusions prepared ahead of the summit, the 27 heads of state and government said they would consider concrete proposals for strengthening the EFSF to ensure the necessary flexibility and financial capacity to provide adequate support, with those discussions being finalized next month.

With no major decisions therefore expected at Friday's meeting, diplomats are describing it as a stock-taking exercise to assess progress since the last meeting in December, since when concerns about the debt crisis spreading from Greece and Ireland to Portugal, Spain or beyond appear to have diminished.

Markets are turning, doubts about the solidity of the euro and the euro zone are dissipating, a source in the French presidency said on Thursday, briefing reporters ahead of the summit. This is the moment to take a great step forward.

After a year of trying to extinguish sovereign debt flames, officials have been heartened by relative calm in financial markets in recent weeks, but recognize that failure to agree on concrete measures before the next scheduled summit on March 24-25 could reignite the conflagration.

In a sign of returning investor confidence, Spain's borrowing costs fell sharply at bond auctions on Thursday. Portugal has also had encouraging recent debt sales.

Strengthening the EFSF has been the focus of discussion for months, since it became clear its effective lending capacity was only about 250 billion euros, not 440 billion, due to guarantees built into the fund to maintain its triple-A credit rating.

Given its lending limitations, there are concerns that if Portugal and Spain were both to end up needing a bailout, the EFSF would not have sufficient funds.

European Central Bank President Jean-Claude Trichet, who will hold talks with EU leaders over lunch, is among those calling for the EFSF to be enlarged and made more flexible, so that it is not just a bailout lender of last resort.

One proposal for increasing the capacity involves the six euro zone member states with triple-A credit ratings increasing their own guarantees, while the remaining 11 would have to make cash deposits to bolster the fund.

Another is to allow the fund to buy the bonds of distressed euro zone states, either directly in the primary market or by lending money to states to buy back bonds, euro zone officials have said.

There is also likely to be discussion on Friday on the bailouts that have already been provided to Greece and Ireland, and on whether the interest rate being charged on their loans should be lowered, or the term of the loans lengthened.

GERMAN RESISTANCE

The EFSF is the chief weapon in the EU's arsenal, but deep disagreement remains over how it should be strengthened, with Germany determined to secure stricter budgetary commitments from other euro zone member states in exchange for agreeing amendments to the fund.

A German government official, at briefing in Berlin on Wednesday ahead of the summit, appeared to close the door on one proposal, saying bond-buying wasn't an option.

It is not in our interest that the EFSF can buy bonds, the official said. This is not practical.

In their proposals for economic coordination, France and Germany will lay out plans for stricter fiscal discipline, including the idea of a debt brake that would establish a constitutional limit on deficits, and calls for more regular euro zone summits to better coordinate economic management.

We want to increase our competitiveness and grow closer together within the Eurogroup and also invite other countries to take part, Merkel said.

Germany's ideas also include raising the pensionable age depending on a country's demographics, limiting wage increases, and agreeing a common tax base for corporations.

Most of the proposals by Berlin and Paris have already been set out by the European Commission in January in its Annual Growth Survey as part of the new, tighter budget coordination process called the European Semester.

I ... expect progress on the comprehensive economic plan we have prepared for the euro area and for the EU as a whole, European Commission President Jose Manuel Barroso said on entering the summit. The ideas presented by some member states fit very well with this overall approach of reinforcing our governance.

There remains the risk that Friday's summit will underline just how far apart states remain, with Germany largely backed by the likes of France, Finland and the Netherlands, while Greece, Italy, Spain and others pull in different directions.

Euro zone officials privately express concerns about how slowly work is progressing and say they doubt whether a complete package can be agreed by late March. Leaders will consider holding an extra summit in early March to maintain momentum.

Friday's summit was originally set up to discuss energy issues. While these remain on the agenda, the debt crisis and the situation in Egypt are likely to dominate the discussion. The leaders are expected to issue a statement on Egypt.

(Additional reporting by Jan Strupczewski in Brussels, editing by Mike Peacock)

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