By Stephen Brown and Jan Strupczewski
BERLIN/BRUSSELS (Reuters) - Germany and France stepped up a drive on Monday for coercive powers to reject national budgets in the euro zone that breach EU rules, as a market rout of European debt eased temporarily on hopes of outside help for Italy and Spain.
The OECD rich nations' economic think-tank said the European Central Bank should cut interest rates and step up purchases of government bonds to restore confidence in the euro area, which now posed the main risk to the world economy.
In Brussels, finance ministers of the 17-nation currency area meeting on Tuesday are due to approve detailed arrangements for scaling up the European Financial Stability Facility rescue fund to help prevent contagion in bond markets, and release a vital aid lifeline for Greece.
Berlin and Paris aim to outline proposals for a fiscal union before a European Union summit on Dec. 9 increasingly seen by investors as possibly the last chance to avert a breakdown of the single currency area.
"We are working intensively for the creation of a Stability Union," the German Finance Ministry said in a statement. "That is what we want to secure through treaty changes, in which we propose that the budgets of member states must observe debt limits."
It dismissed a report by the newspaper Die Welt that Germany and the five other euro zone states with top-notch AAA credit ratings could issue joint bonds for themselves and partners.
Moody's Investors Service warned that the rapid escalation of the euro zone sovereign debt and banking crisis threatened all European government bond ratings.
"While Moody's central scenario remains that the euro area will be preserved without further widespread defaults, even this 'positive' scenario carries very negative rating implications in the interim period," the ratings agency said in a report.
Finance Minister Wolfgang Schaeuble acknowledged on Sunday that it may not be possible to get all 27 EU member states to back treaty amendments, saying agreement should be reached among the 17 euro zone members.
"That can be done very quickly," he told ARD television, adding that it only required changing an additional protocol to the EU's Lisbon Treaty.
Sources familiar with the Franco-German negotiations said they were also exploring a deal among a smaller number of countries outside the EU treaty if necessary.
"END OF THE EURO"?
The leaders of two smaller euro zone countries, Finland and Luxembourg, voiced unease about the Franco-German plans because they appeared to bypass the European Commission, which is seen as a guarantor of equal treatment for all member states.
"We don't find this type of system good and I am not too sure if it will get wider support. The disadvantage of this proposal is that it would bypass the EU, the Commission would have a very small role," Finnish Prime Minister Jyrki Katainen told reporters.
Luxembourg Prime Minister Jean-Claude Juncker, who chairs euro zone finance ministers, also warned against looking for instruments outside the EU treaty.
In France, Agriculture Minister Bruno Le Maire said euro zone countries would have to give up some budget sovereignty to save the euro from hostile "speculators".
"We won't be able to save the euro if we don't accept that national budgets will have to be a bit more controlled than in the past," Le Maire told Europe 1 radio.
"We are in an economic war with a number of powerful speculators who have decided that the end of the euro is in their interest," he said.
Handing over fiscal sovereignty to the executive European Commission is politically sensitive in France, which has a strong Gaullist, nationalist tradition.
President Nicolas Sarkozy's office sought to quash a weekend newspaper report that Berlin and Paris were planning to confer "supranational powers" on Brussels, suggesting such intrusion would only apply to countries such as Greece that were under EU/IMF bailout programmes.
Asked whether the Commission would be granted intrusive powers over national budgets in the euro zone, Le Maire said: "Why not? The French people have to realise what is at stake -- the preservation of our common currency and our sovereignty.
"We'll see if it's the council (of ministers) or some other European institution (that exercises these powers). What matters is that we ensure that budget discipline is respected within the euro zone. Otherwise the euro itself is threatened."
He acknowledged that France and Germany were still at odds over greater ECB intervention to rescue the euro but said: "We will have to find a compromise."
On financial markets, the euro regained ground after slipping below $1.33 in Asia and European shares jumped on hopes of fresh measures to fight the debt crisis. Italian, Spanish, French and Belgian bond yields fell, as did the cost of insuring those countries' debt against default.
But relief may be short-lived as the rally was partly due to an Italian newspaper report that the International Monetary Fund was in talks to lend Italy up to 600 billion euros -- more than its entire war chest -- which the IMF flatly denied.
The European Commission also said Italy had not asked for any amount of money and there were no discussions at European level on aid for Rome.
IMF inspectors are due in Rome this week to examine Italy's public finances after former Prime Minister Silvio Berlusconi agreed earlier this month to submit to regular monitoring of his promised austerity measures and economic reforms.
IMF TO THE RESCUE?
EU officials say some sort of IMF programme could make sense for both Italy and Spain as part of a multi-pronged response, involving the ECB and the euro zone rescue fund, to supervise reforms and restore investor confidence in their debt.
A senior EU source confirmed that both Berlusconi and the European authorities had rejected an IMF offer of a 50 billion euro precautionary credit line for Italy in talks on the sidelines of the Cannes G20 summit on Nov 3. The source said the sum would have been insufficient to convince markets.
Reuters reported exclusively last week that Spain's People's party, due to form a government by mid-December, is considering seeking IMF aid as one option for shoring up public finances.
In its world economic outlook, the Organisation for Economic Cooperation and Development forecast growth in the euro area will slow -- under a baseline scenario of "muddling through" -- to 0.2 percent in 2012 from an estimated 1.6 percent in 2011.
Urging "a substantial relaxation of monetary conditions", the OECD said banks would need to be well capitalised and policies put in place for sovereigns to finance themselves at reasonable rates.
"This calls for rapid, credible and substantial increases in the capacity of the EFSF together with, or including, greater use of the ECB balance sheet," the OECD said.
OECD chief economist Pier Carlo Padoan said current plans to leverage the euro zone bailout fund were insufficient. What was needed was a multiple of what was currently on the table.
Euro zone leaders initially planned to leverage the EFSF up to 1 trillion euros, but the fund's head said it is now unlikely to achieve that.
EFSF chief Klaus Regling was quoted by lawmakers as telling German coalition lawmakers that leveraging by a factor of 4-5 was "no longer reachable because of the clear deterioration of the market environment". Instead, it might be 3-4 times the fund's size.
The fund has had trouble selling its own bonds to raise funds and has yet to attract the pledges it hoped to get from countries with sovereign wealth to invest.
(Additional reporting by Leigh Thomas in Paris, Emelia Sithole-Matarise in London, Matthias Sobolewski in Berlin, Ian Chua in Singapore,; writing by Paul Taylor; editing by Philippa Fletcher/Mike Peacock)