Eurozone looks at Greek exit as leaders meet

BRUSSELS (Reuters) - European leaders, at odds over how to resolve the deepening crisis in the euro zone on Wednesday, have been advised by senior officials to prepare contingency plans in case Greece quits the single currency area.

Three officials told Reuters the instruction to be ready was agreed on Monday during a teleconference of the Eurogroup Working Group (EWG) - experts who work for the bloc's finance ministers - and the German central bank said losing Greece would be testing but "manageable".

"The EWG agreed that each euro zone country should prepare a contingency plan, individually, for the potential consequences of a Greek exit from the euro," said one euro zone official.

The Greek finance ministry denied there was any such agreement but Belgian Finance Minister Steven Vanackere, asked by reporters ahead of the EU summit, said:

"All the contingency plans (for Greece) come back to the same thing: to be responsible as a government is to foresee even what you hope to avoid."

The news comes at a highly sensitive time with EU leaders gathering to try to breathe life into their struggling economies at a summit over dinner on Wednesday.

Although minds will be focused by the prospect of Greece leaving the currency area, something EU leaders insist they want to avoid, disagreements over a plan for mutual euro zone bond issuance and other measures to alleviate two years of debt turmoil have already been laid bare.

In its monthly report, Germany's Bundesbank said the situation in Greece was "extremely worrying" and it was jeopardizing any further financial aid by threatening not to implement reforms agreed as part of its two bailouts.

It said a euro exit would pose "considerable but manageable" challenges for its European partners, raising pressure on Athens to keep its painful economic reforms on track.

Greek officials have said that without outside funds, the country will run out of money within two months and there remains the threat that if it crashes out of the euro zone, other member states could be targeted by the markets.

For the first time in more than two years of crisis meetings, the leaders of France and Germany have not huddled beforehand to agree positions, marking a significant shift in the Franco-German axis which has traditionally driven European policymaking.

Instead, new French President Francois Hollande met Spanish Prime Minister Mariano Rajoy in Paris to discuss policy, before the pair travelled to Brussels.

Despite fears Greeks could open the departure door if they vote for anti-bailout parties at a June 17 election, Spain, where the economy is in recession and the banking system is in need of restructuring, is at the front line of the crisis, with concerns growing that it too could need bailing out.

After meeting Hollande, Rajoy said he had no intention of seeking outside aid for Spain's banks, although his government said its rescue of problem lender Bankia would cost at least 9 billion euros ($11 billion).

SHIFTING SANDS

Socialist Hollande's election victory has significantly changed the terms of the debate in Europe, with his call for greater emphasis on growth rather than debt-cutting now a rallying cry for other leaders.

That has set up a showdown with conservative German Chancellor Angela Merkel, who supports growth but whose primary objective is budget austerity and structural reform.

At his first EU summit, Hollande has chosen to make a stand on euro bonds - the idea of mutualising euro zone debt - despite consistent German opposition to the idea.

He has support from Italian Prime Minister Mario Monti and European Commission President Jose Manuel Barroso, among others. But Merkel shows no sign of dropping her objections to the proposal, which she has said can only be discussed once there is much closer fiscal union in Europe.

The Netherlands, Finland and some smaller euro zone member states support her. "Euro bonds (are) not something we are in favor of, they would increase our borrowing costs," Dutch Prime Minister Mark Rutte said.

Arriving in Brussels, Merkel showed no sign of budging either. "I will propose that the mobility of labor market be improved," she said. "Secondly, it's about structural reform."

No decisions will be made at Wednesday's summit, which is intended to promote ideas on jobs and growth ahead of another meeting at the end of June.

But it is clear debate will be intense, not just over euro bonds but over how to rescue European banks and whether to give more time to struggling euro zone countries to meet their budget deficit goals.

"We haven't come together to confront each other ... but we have to say what we think - what are the right instruments, the right methods, the right steps, the right initiatives to raise growth," Hollande said.

Having rallied on Tuesday, European stocks dropped 2.2 percent as investors priced in a lack of dramatic policy intervention. The euro tumbled against the dollar to its lowest since August 2010 and Spanish and Italian borrowing costs climbed.

A German two-year debt auction gave a stark illustration of how money is dashing for safe havens. Investors snapped up the 4.5 billion euros of paper on offer even though it came with a zero coupon - offering no return at all.

As well as exploring ways to foster growth, the leaders will assess how to stabilize their banking systems, particularly Spain's which is laden with bad debts from a property boom that bust and still has some way to go before it touches bottom.

One proposal on the table is for the euro zone's rescue funds to be allowed to recapitalize banks directly, rather than having to lend to countries for on-lending to the banks.

But that is another idea with which Germany is uncomfortable.

"The top priority is injecting liquidity into the European financial system to ensure that European banks, all European banks, can be consolidated," Hollande said.

SEARCH FOR GROWTH

With the euro zone registering no growth in the first quarter of the year and threatening to slip back into recession, the formal summit agenda is jobs and growth, with policymakers touting three ideas they hope will provide near-term stimulus:

- 'Project bonds' backed by the EU budget to finance infrastructure projects alongside private sector investment.

- Doubling the paid-in capital of the European Investment Bank, the EU's co-financing arm, to a little over 20 billion euros.

- Redirecting structural funds which tend to flow to poorer countries, to other areas where they might reap more immediate growth rewards.

Even if all three proposals were to be activated quickly economists and analysts say they will not provide a sufficient shot in the arm to the euro zone and the wider EU economy.

(Additional reporting by Luke Baker and Marine Hass in Brussels, Julien Toyer in Madrid and Catherine Bremer in Paris, writing by Mike Peacock, editing by Anna Willard and Giles Elgood)