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Merkel agrees to recapitalize EU banks with bailout funds

BRUSSELS — European leaders surprised markets, analysts and themselves Friday by striking a pre-dawn agreement that is perhaps their most comprehensive effort so far to resolve the euro zone debt crisis.

"It is a seismic shift in European policy," said Irish Prime Minister Enda Kenny of the agreement. "What was deemed to be unachievable has now become a reality."

After tough negotiations that dragged on through the night here at the Justus Lipsius building, the European leaders struck a deal at 5 a.m. It's designed to ease immediate market pressure on the beleaguered Spanish and Italian economies, while meeting French demands for a stimulus package to boost growth, and building new safeguards to protect Spain's wobbly banks.

"We now have a coherent framework," said French President Francois Hollande.

Hours after Italy's soccer team had pulled off a shock defeat of Germany in the semi-final of the European Championship, the summit deal was inevitably viewed as a victory for Italian Prime Minister Mario Monti over German Chancellor Angela Merkel.

"Monti emerged from the late-night negotiations as a clear victor, having broken Chancellor Angela Merkel's resistance, just as Italian striker Mario Balotelli cracked the German defense on the pitch," wrote the online edition of the German news weekly Der Spiegel.

However, although Merkel gave ground on a number of points, she also archived a commitment from the other 16 euro zone leaders to work toward her long-term goal of a political and fiscal union that will bind them all to German-style budget discipline and prevent them from running up ballooning debts in the future.

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"We have remained completely true to our existing model: performance, reward, conditionality and control," Merkel told reporters. "We've done something important and remained true to our philosophy: no reward without performance."

Merkel clearly blinked in agreeing to use the EU's 800 billion euro ($1 trillion) bailout funds to directly recapitalize troubled banks, without having to go through national authorities, and by accepting Monti's proposal to empower the funds to intervene more freely in support of countries threatened by the bond markets.

"Italy got what it wanted. Monti showed he's the only one with leverage over Merkel," said Piotr Kaczynski, head of program at the Center for European Policy Studies, a think tank. "But I don't think it's a defeat for Merkel. She has shown her readiness to compromise, that she is dedicated to saving the euro."

The agreement aims to break the so-called "doom loop" that entwines bank and government debt together, and has dragged down economies like Spain and Ireland.

Under Friday's deal, the EU bailout funds will be able to lend directly to troubled banks, without channeling their loans through national treasuries and adding to the sovereign debt of nations. Countries will also no longer be required to reimburse Europe's bailout loans before repaying other creditors; previously, that provision scared off private investors, who feared that their hundreds of billions of euros in senior obligations could prevent governments from paying them back.

Both those measures are designed to ease pressure on Spain which has seen the interest it has to pay on bonds rise dramatically since accepting a 100 billion euro bank bailout from the EU earlier this month.

In return, Spain and Italy have agreed to German demands for greater centralized supervision of the European banking sector, including the creation of an EU body that can oversee the winding down of unviable banks.

Those plans for a European "banking union" are due to be in place by the end of 2012. They should also include an EU-wide guarantee scheme to protect savers' deposits and head off the risk of bank runs.

Monti's main achievement was securing an agreement that will make it easier for the EU bailout funds to buy up the bonds of nations under attack by the markets.

That safeguards Spain and Italy from the market pressure that forced Greece, Ireland and Portugal to seek EU bailouts because they could no longer pay the interest rates on their bonds.

"The euro zone will be strengthened by this," said Monti. The deal boosts the domestic position of the Italian prime minister who faces mounting opposition to government austerity measures, notably from his predecessor Silvio Berlusconi.

Monti and his Spanish counterpart Mariano Rajoy played hardball at the summit, warning of dire consequences if there was no deal, and threatening to veto other measures unless they got concessions on the bank and bond market issues.

Hollande was particularly pleased with the new EU "growth pact" which should funnel 120 billion euros into job-creation schemes like improving transport and digital communication links, particularly in the hardest-hit nations.

However, there is little new public money in the package. A breakdown shows 40 billion euros come from unused EU funds already earmarked for such projects; over 60 billion euros should come from private investments leveraged by a 10 billion euro increase in the capital of the EU's investment bank, and around 5 billion euros are to come from new euro project bonds.

The leaders also agreed to raise funds through a new tax on financial transactions. Hollande told reporters the tax should be in place by the end of the year, although some EU members, notably Britain, will opt out.

EU experts are scheduled to come up with detailed plans for the implementation of the banking union and the fiscal union sought by Merkel at their next scheduled summit in October.

"Merkel is not giving away any gifts here, she is also getting what she wants," said Hans Martens, chief executive of the European Policy Centre think tank. "This summit is certainly a bit of a surprise ... there has been a stroke of genius here, so every one can claim victory."

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All eyes are now on the markets. They responded positively in the hours after the summit decisions, with European stocks and the euro soaring while rates eased on Spanish, Italian and Irish bonds.

However, temporary euphoria is common after EU summit decisions and doubts are quickly beginning to creep in over whether the EU bailout funds have sufficient firepower should they be called upon to support Italian and Spanish bonds.

Friday's agreement may have bought the euro zone some time, but the leaders will need to act decisively to shore up longer-term measures. To do that, they will have to reconcile Germany's aversion to sharing out the debt burden without cast-iron EU controls over national budgets with France's unease over handing over more power to Brussels or Berlin.

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