By Luke Baker
BRUSSELS (Reuters) - European leaders will explore ways of breathing life into their stricken economies at a summit on Wednesday, but the issue of euro-zone bonds and whether they can help alleviate two years of debt turmoil will dominate the meeting.
Prime Minister Mariano Rajoy of Spain, where the economy and banking system are at the frontline of the crisis, will meet newly elected French President Francois Hollande in Paris ahead of the evening summit to discuss policy positions - a marked shift away from the traditional Franco-German axis.
At nearly all previous summits over the past two years, Hollande's predecessor Nicolas Sarkozy met German Chancellor Angela Merkel beforehand to fix a strategy, prompting criticism from other leaders about diktats from Paris and Berlin.
In that respect, Hollande's victory has significantly changed the terms of the debate, with his call for greater emphasis on growth now a rallying cry for other leaders. That has set up a showdown with Merkel, who supports growth but whose primary objective is budget austerity and structural reform.
In his first EU summit, Hollande has also chosen to make a stand on euro bonds - the idea of metalizing euro zone debt - despite strong German opposition to an idea that has been hotly debated for more than two years.
He will have support from Italian Prime Minister Mario Monti and European Commission President Jose Manuel Barroso, among other leaders. 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, Austria and some smaller euro zone member states support her in that position.
"(Euro bonds) are the wrong prescription at the wrong time with the wrong side-effects," Germany's deputy finance minister, Steffen Kampeter, said this week, a position further underlined by other German government officials on Tuesday.
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 that the debate over euro bonds and related bank rescue concerns will be intense.
EURO BONDS "ROAD MAP"
Olli Rehn, the European commissioner for economic affairs, threw his weight behind the proposal on Tuesday, saying it was time for a "road map" setting out the legal and fiscal steps need to bring about euro-zone bonds in the years ahead.
And Herman Van Rompuy, the president of the European Council, the body which represents EU leaders, said heads of state and government should abandon taboos as they think about the future of Europe and its economic framework.
"It is not too early to think ahead and to reflect on possible more fundamental changes to economic and monetary union," he wrote in a letter to the 27 EU leaders.
"In many ways, the perspective of moving towards a more integrated system would increase confidence in the euro and the European economy generally."
As well as exploring ways of resolving the sovereign debt problems that have torn the economies of Greece, Portugal and Ireland apart and threaten the stability of the euro, the leaders will assess how to stabilize their banking systems.
Spain is a particular concern, with a number of its banks laden with bad debts incurred by excessive lending during a property boom that has long since turned to bust and still has some way yet to go before it touches bottom.
The total amount of bad debt is estimated at more than 180 billion euros ($240 billion), while efforts to recapitalize and restructure the stricken banks have so far fallen short.
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, even though Merkel said on Tuesday it was necessary to come up with a way of dismantling banks across borders, a possible nod to a pan-eurozone bank restructuring scheme.
The formal agenda of Wednesday's meeting is jobs and growth, and specifically three ideas policymakers hope will provide some near-term stimulus to the European economy, which is barely growing and threatens to slip into recession.
On Tuesday, agreement was reached with the European Parliament on 'project bonds', instruments backed by the EU budget that can be used to finance energy, transport and telecoms projects alongside private sector investment.
A pilot program, using EU capital of 230 million euros, will run until 2013 and if successful could lead to up to 4.6 billion euros of new investment, EU officials say.
There is also a proposal to double the paid-in capital of the European Investment Bank, the EU's co-financing arm, to a little over 20 billion euros. That would increase its leverage and could eventually release up to 180 billion euros for investment in infrastructure.
Agreement on that proposal could be reached by the June 28-29 summit, but there remains opposition from some member states concerned that viable investment targets have to be identified first and that the EIB's strong track record could be undermined if money is thrown at bad projects.
The third initiative is to redirect EU structural funds - money from the EU's multi-year budget used to help poorer countries improve their infrastructure - to other areas where it might reap more immediate growth rewards.
The figures remain vague, and even if all three proposals were to be activated quickly - a big 'if' - economists and analysts are not convinced that would provide a sufficient shot in the arm to the euro zone and wider EU economy.
The bigger concern remains finding ways of resolving the sovereign debt and banking problems sapping euro zone economies, and pushing through the structural reforms to pension systems and labor markets that might make euro zone economies more competitive in the wider world and so better able to grow.
(Editing by Alastair Macdonald)