European shares fell and the euro hit a seven-week low on Friday, as a spiraling debt crisis and the lack of a comprehensive policy to contain the damage sapped investor confidence.

Bond market borrowing costs grew for the governments struggling most after two years of debt turmoil, with appetite for Italian short term debt set to be tested at an auction later in the day.

Italy will sell up to 8 billion euros of 6-month treasury bills with yields indicated at 5.85 percent in the grey market late on Thursday.

That compared with a gross yield of 3.535 percent at the last sale of 6-month bills a month ago, and highlighted how borrowing costs of so-called peripheral euro zone nations are rising to unsustainable levels.

The interest rate premium investors charge Italy to borrow over 10 years compared to equivalent German bonds rose by 15 basis points. Two-year bond yields hit a euro era high of 7.72 percent.

European stocks lost ground for the ninth time in 10 sessions and were on course to post their biggest weekly loss in two months. The FTSEurofirst 300 <.FTEU3> index of top European shares was down 0.3 percent at 896.88 points.

It has lost about 13 percent since late October as investors fretted over the slow pace of progress of efforts to contain the debt crisis and Germany's persistent opposition to the idea of joint euro zone bonds and an expanded role for the European Central Bank.

French President Nicolas Sarkozy and Germany's Chancellor Angela Merkel, after talks with Italian Prime Minister Mario Monti on Thursday, agreed only to stop bickering in public over whether the ECB should do more to resolve the crisis.

Jonathan Sudaria, a stock dealer at Capital Spreads said as long as Germany was opposed to the idea of euro bonds, shares would continue to fall.

Yesterday's meeting sapped traders' hopes for the creation of a euro bond, as it was made resolutely clear that EU policy makers intend to try and solve the debt crisis through increasing fiscal union, he said.

He adding such a solution would be a long drawn-out process and was exactly opposite to what markets were looking for to restore confidence.

BANK WORRIES

A growing concern in the past month has been signs of stress on the bank-to-bank lending markets which were at the heart of the financial sector turmoil three years ago.

Funding problems for European banks have escalated, with the cost of swapping euros into dollars in the currency swap market reaching three-year highs of 148 basis points on Thursday.

The ECB is looking at extending the term of loans it offers banks to 2 or even 3 years to try to prevent the euro zone crisis precipitating a credit crunch that chokes the bloc's economy, people familiar with the matter say.

The euro fell to a seven-week low against the dollar, dropping to $1.3295 and down 0.4 percent on the day.

Merkel sees no scope for euro bonds and the ECB continues to make it clear it sees no scope for financing public debt, said Manuel Oliveri, currency strategist at UBS in Zurich.

Without agreement on either of those two factors there is not much chance of an improvement in sentiment toward the euro and we think it can go lower from here still.

(Additional reporting by Atul Prakash and Neal Armstrong; Editing by)

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