Fears intensified of a fresh global slump on Tuesday as it emerged that Europe's leaders were still at loggerheads over a three-pronged plan to save the single currency.
Hopes that summits in Brussels on Wednesday would deliver a "grand bargain" that would finally draw an end to an 18-month sovereign debt crisis were fading fast as talks planned for Wednesday morning were cancelled, rumours surfaced of a collapse in Silvio Berlusconi's Italian government and the German chancellor, Angela Merkel, adopted a hard line in negotiations with her French counterpart, Nicolas Sarkozy, over the shape of a rescue package.
The lack of progress forced the cancellation of a meeting of the EU's 27 finance ministers, including Britain's George Osborne, in Brussels on Wednesday.
However, two meetings – the first involving leaders of all 27 European Union countries and the second limited to the 17 members of the single currency – are expected to proceed, to the despair of several EU diplomats.
"Everybody realises that we are on the brink of such a total catastrophe that anything that prevents it and a huge recession must be grasped," one EU diplomat said. "The markets will kill us if they haven't laughed themselves to death."
Shares have been rising in the past few days amid speculation that Wednesday's meetings, delayed from the weekend to give officials more time to piece together a deal, would agree the terms of a Greek debt write-down, bolster the firepower of Europe's bailout fund – the European Financial Stability Facility (EFSF) – and pump up to €108bn into Europe's weakest banks. Negotiations continued into the night on each strand.
But with receding expectations of a deal, even in political outline, that could be signed, sealed and delivered by early Thursday, sources said the only hope of a "miracle" lay in a meeting of senior euro working group officials late on Tuesday.
Shares fell sharply late on in Europe and in New York as evidence of a potential failure began spooking markets. At a Senate hearing in Washington, Charles Collyns, a senior US treasury official, said: "The European financial crisis presents the most serious risk today to global recovery and the prospects for US exports and American jobs."
But he said: "We do think they are going to take action comprehensively in the next few days." The US has been putting intense pressure on Europe to "get its act together" amid concerns that the crisis will push the world economy into a double-dip recession. Washington is eager for a deal to be agreed before Barack Obama travels to Cannes for next week's summit meeting of the G20 group of developed and developing countries.
Such was the gravity of the situation on Tuesday night that there were reports that the International Monetary Fund was considering putting money into the EFSF to spare cash-strapped European governments the cost of adding more capital to the €440bn (about £380bn) facility. The IMF believes Europe needs to have €2tn at its disposal to head off market pressure on the two big problem countries, Italy and Spain, and has been exploring with Brussels ways of leveraging up the EFSF's resources.
A suggestion doing the rounds of Brussels corridors is that Wednesday'ssummit could reach a last-minute political agreement, leaving finance ministers to sort out the complex technical issues later this week – perhaps even at the weekend.
But this has already prompted analysts to question whether the EU can ever get its act together and be ahead of the market curve. "The job facing European leaders is no small one and can be likened to climbing Everest without crampons," said Angus Campbell at Capital Spreads.
Brian Barry, a bond market expert at Evolution Securities, said: "It's coming down to the wire. It's about restoring confidence. There has been very little so far to do that. Something has to be done. If this doesn't work to restore confidence it will be quite worrying."
In Germany, Merkel upped the ante by explicitly rejecting part of a draft eurozone summit communique which appeared to urge the European Central Bank to buy up more Italian and Spanish bonds. She said Germany refused to accept this wording on "non-standard measures" – which can also refer to the ECB's version of quantitative easing or limitless liquidity.
Indeed, in a draft resolution signed by all political parties for Wednesday's session of the full Bundestag on enhancing the EFSF's firepower, German MPs set out the expectation that the ECB would give up its bond-buying programme once the EFSF had been leveraged up. The motion, likely to be endorsed by an overwhelming majority, also calls for a financial transaction tax.
Merkel said: "We're in an area here where we're all entering virgin territory." Merkel and Sarkozy have put severe pressure on Berlusconi to arrive at Wednesday's summits with precise plans to slash Italy's ¤1.9tn debt, which stands at 120% of GDP, and reboot its stagnant economy.
Berlusconi has been battling over pension reform with his coalition partner the Northern League and continued to hold talks at his residence in Rome on Tuesday, with promised proposals due in Brussels by the afternoon delayed. The Italian prime minister was not mollified by European commission spokesmen saying the aim was not to humiliate Italy or punish it.
Simultaneously, private creditors remained locked in negotiations with the commission and ECB about the "haircuts" that need to be agreed if Greek debt is to be written down in an orderly fashion.
Jean-Claude Juncker, the eurogroup chairman, made it plain that the EU was still seeking 50% or more, compared with the 21% agreed voluntarily in July when an outline second bailout programme of ¤109bn for Greece was agreed. The banks, led by the outgoing Deutsche Bank chief Josef Ackermann, have offered 40% amid accusations that EU negotiators are holding a gun to their heads and actually want 60%.
With this key issue unresolved, the boost to the EFSF's firepower has not yet been agreed either. Part of the EFSF has already been pledged to help Greece, Ireland and Portugal but the market expectation is that the remainder will be leveraged fivefold to provide a war chest of between €1.25tn and €1.5tn. Officials confirmed that several variants are under discussion, all of which involve the fund acting as an insurer or guarantor for a slice of the losses – around 20% – that could be suffered by institutional or private bondholders.
Draft documents circulating in the Bundestag confirm that both the IMF and sovereign wealth funds from Asia and the Gulf could play a central role in marshalling the EFSF's increased firepower.
Additional reporting by Dominic Rushe in New York and Tom Kington in Rome
guardian.co.uk © Guardian News and Media Limited 2010