By Noah Barkin and Leigh Thomas
BERLIN/PARIS (Reuters) - Germany dismissed a French-led call for euro zone nations to issue common bonds, a day before a European Union leaders' summit which investors are looking to for new measures to counter the bloc's debt crisis.
After a torrid week, stock markets rallied on optimism that the Wednesday summit would produce measures to foster growth and ward off the threat of contagion should Greece exit the euro.
The FTSEurofirst 300 index of top European shares was up 1.2 percent by 1230 GMT and Spanish and Italian borrowing costs fell, leaving scope for disappointment if the EU leaders underwhelm.
French President Francois Hollande will push a proposal for metalizing European debt at the informal summit, a scheme which many economists and policymakers say could be one of the most effective ways of restoring market confidence.
Hollande has also called for a focus on growth rather than austerity.
But there is no sign that Germany, the EU's paymaster, is prepared to soften its opposition. It says more progress is needed first on coordinating fiscal policies, a stance in which it has the backing of the Netherlands, Finland and Austria among others.
"Tomorrow's meeting will not deliver any landmark solution. The market is likely to be more prone to disappointment," said Matteo Regesta, a strategist at BNP Paribas.
A senior German official said Berlin did not believe jointly issued euro zone bonds were the solution and would not change its view, at least in the near-term.
"That's a firm conviction which will not change in June," the official said at a German government briefing. A second summit will be held at the end of next month.
The official, requesting anonymity, also said he saw no need for leaders to discuss at Wednesday's meeting a loosening of deficit goals for struggling countries like Greece or Spain, or to explore new ways to recapitalize vulnerable banks.
With Greece facing elections on June 17 that could hasten its departure from the euro zone if voters back anti-bailout parties, German Chancellor Angela Merkel was put under some pressure at a weekend G8 summit, but refused to budge on her insistence that any growth measures could not come via more deficit spending.
Without her agreement, no major policy shift will be possible.
The growth measures that are on the table - including boosting the paid-in capital of the European Investment Bank and plans for "project bonds" underwritten by the EU budget to finance infrastructure - will help, but most economists say they are nowhere near enough to turn the euro zone economy around.
The currency bloc appears to be heading back into recession having registered no growth in the first quarter.
Some major companies are feeling the pinch too.
Mobile phone operator Vodafone for instance cut its medium-term sales target and took a writedown of 4 billion pounds ($6.3 billion) as cash-strapped customers in Spain, Italy, Greece and Portugal made fewer calls.
In its twice-yearly economic outlook, the Paris-based Organisation for Economic Co-operation and Development forecast the 17-member economy would shrink 0.1 percent this year and said its debt crisis could still spiral out of control, with Greece struggling to remain solvent and Spanish banks needing to be recapitalized.
"The situation over the past few weeks has changed dramatically," OECD chief economist Pier Carlo Padoan told Reuters. "If the situation gets worse, there are ways to enhance the firewall capacity which could include a stronger intervention or role of the ECB."
INJECTION OF LIQUIDITY
The OECD said the European Central Bank should not rule out buying government bonds again to keep borrowing costs down, lending directly to the ESM European bailout fund as well as cutting its main interest rate, which stands at 1.00 percent.
It could also consider another injection of liquidity into the banking system. The central bank's creation of more than 1 trillion euros ($1.3 trillion) of three-year money in December and February brought some temporary calm to the currency bloc.
As things stand, most of those options are opposed by at least some within the ECB governing council.
Speaking in London, International Monetary Fund chief Christine Lagarde said euro zone firewalls were a "work in progress".
Markets face an unsettling month before the Greek elections and are also concerned about the shaky state of Spain's banking system and high debts. Madrid admitted on Friday its 2011 budget deficit was even higher than first thought.
Spain raised 2.5 billion euros in three- and six-month Treasury bills on Tuesday, the top end of the targeted range, at significantly higher yields than it paid investors for the same maturities a month earlier.
Greece, the cradle of the debt crisis, will recapitalize its four largest commercial banks to the tune of 18 billion euros, a senior banker said.
The funds, which will come from the euro zone's EFSF rescue fund, are needed to recapitalize Alpha Bank, National Bank of Greece, EFG Eurobank and Piraeus Bank, and will allow them to take liquidity funding from the ECB again, the banker said.
(Additional reporting by George Georgiopoulos, Angelika Gruber, Kate Holton and Emelia Sithole-Matarise; Writing by Mike Peacock; Editing by David Holmes)