A "disastrous" German bond sale on Wednesday sparked fears that Europe's debt crisis was even beginning to threaten Berlin, with the leaders of the eurozone's two strongest economies still firmly at odds over a longer-term structural solution.
Financial markets were also unnerved by newspaper reports that Belgium may be pressing France for an expansion of a 90 billion euro ($120 billion) bailout of failed bank Dexia.
On top of this, a special report by Fitch Ratings suggested France had limited room left to absorb shocks to its finances like a new downturn in growth or support for banks without endangering its cherished AAA credit status.
After one of the least successful debt sales by Europe's powerhouse economy since the launch of the single currency, the euro fell and European shares sank to 7-week lows.
The Bundesbank was forced to retain almost half of a sale of 6 billion euros due to a shortage of bids by investors. The result pushed the cost of borrowing over 10 years for the bloc's paymaster above those for the United States for the first time since October.
"It is a complete and utter disaster," said Marc Ostwald, strategist at Monument Securities in London.
One senior ratings agency official said the rise in its own borrowing costs could even give Germany a pause to re-examine its refusal to embrace a broader solution to resolve the debt crisis.
"It's quite telling that there has been upward pressure on yields in Germany - it might begin to change perceptions in Germany," David Beers of Standard & Poor's told an economic conference in Dublin.
The new bond promised to pay out a 2.0 percent interest rate — the lowest ever on an issue of German 10-year Bunds. The average yield at the auction was 1.98 percent, down from 2.09 percent at the last sale of the previous benchmark in October.
Signs that European banks are increasingly shut out of credit markets and reliant on the European Central Bank for funding have added to pressure for the bloc's leaders to find a broad and lasting solution to the crisis.
But Germany and France clashed again over whether the ECB should take bolder steps to ease the pressure on debt markets in Italy, Spain and others which is now at the heart of the crisis.
ECB MANDATE "CANNOT BE CHANGED"
In a forceful speech to the Bundestag lower house of parliament, Chancellor Angela Merkel issued one of her starkest warnings yet against fiddling with the central bank's strict inflation-fighting mandate. She also hit back at proposals from the European Commission on joint eurozone bond issuance, calling them "extraordinarily inappropriate."
"The European currency union is based, and this was a precondition for the creation of the union, on a central bank that has sole responsibility for monetary policy. This is its mandate. It is pursuing this. And we all need to be very careful about criticizing the European Central Bank," Merkel said.
"I am firmly convinced that the mandate of the European Central Bank cannot, absolutely cannot, be changed."
Shortly before she began speaking, French Finance Minister Francois Baroin offered a polar opposite view on the ECB's role, telling a conference in Paris that it was the central bank's responsibility to sustain activity in the currency bloc.
"The best response to avoid contagion in countries like Spain and Italy is, from the French viewpoint, an intervention (or) the possibility of intervention or announcement of intervention by a lender of last resort, which would be the European Central Bank," Baroin said.
The very public jousting underscores just how divided European leaders are on how to resolve the turmoil which has accelerated to engulf big countries like Italy and Spain, and pushed out leaders in Rome and Athens.
Baroin pointed to market intervention by the U.S. Federal Reserve, Swiss National Bank and Bank of England as a model for the ECB. But Merkel said it was impossible to compare the role of the ECB, which sets monetary policy for 17 countries, with those of national central banks.
With time running out for politicians to forge a crisis plan that is seen as credible by the markets, the European Commission presented a study on Wednesday of joint eurozone bonds as a way to stabilize debt markets.
Some leading European politicians, including Luxembourg Prime Minister Jean-Claude Juncker, support the bonds. But Berlin has rejected them outright as a near-term solution to the crisis, saying they would raise Germany's borrowing costs and reduce incentives for other eurozone countries to get their fiscal houses in order.
In her speech, Merkel pointed to repeated violations of the EU's Stability and Growth Pact in the currency area's first decade, saying they had damaged market faith in the bloc's ability and willingness to crack down on fiscal rule-breakers.
"And this is why I find it extraordinarily inappropriate that the European Commission is suggesting various options for euro bonds today — as if they were saying we can overcome the shortcomings of the currency union's structure by collectivizing debt. This is precisely what will not work," Merkel said.
MERKEL WARNS GREECE
The German leader also sent a clear warning to Antonis Samaras, the leader of conservative New Democracy in Greece, who has resisted pressure to join other political parties and make a written commitment to painful austerity measures.
Merkel said Greece would not receive an 8 billion euro aid tranche it needs to avert a default next month unless Samaras signed the pledge.
Merkel raised pressure on the bloc to finalize plans for a "leveraging" of its rescue fund and a recapitalization of vulnerable banks, saying guidelines were needed by the time European finance ministers meet on Nov. 29-30.
"The fact that we have been talking about (bank recapitalizations) for weeks but still have no clarity is not very reassuring, and yesterday we saw with the example of one German bank how fragile the banks themselves are," Merkel said.
Shares in Germany's second-biggest lender, Commerzbank, tumbled on Tuesday after people close to the bank told Reuters it needs considerably more capital than previously expected to meet the core capital targets demanded by the EU by mid-2012.
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