(Reuters) - Talk of beefing up the euro zone's bailout fund lifted stocks on Tuesday but complicated the debate in Germany where Angela Merkel is struggling to rally her coalition behind her in aiding Europe's weak economies and banks.
European shares rallied for a second day and safe-haven German bonds fell on reports that European policymakers were preparing more decisive action to tackle the bloc's sovereign debt crisis by leveraging up the 440 billion euro rescue pot.
German Finance Minister Wolfgang Schaeuble was forced to deny that any further increase in the bailout fund is planned in a bid to calm irate lawmakers in the center-right coalition. Parliament holds a crucial vote on Thursday on July's EU agreement to extend the scope of the existing fund.
"We do not intend to increase it," Schaeuble told n-tv.
That didn't directly address the question of whether the EFSF fund could be leveraged to raise more money to prevent contagion spreading from Greece to Italy and Spain, the euro zone's third and fourth economies.
While leveraging the fund to borrow more money for financial firefighting would not require an increase in the EFSF's size, critics say it could raise German taxpayers' liability for any losses. Some lawmakers are concerned that EU officials are just waiting for them to approve what they were assured would be the final increase before pressing ahead with bigger bailout plans.
French Finance Minister Francois Baroin made clear there were tactical reasons to avoid discussing how to boost the fund's financial firepower before the German decision.
Asked at a dinner in Paris whether there was a need to boost the EFSF, he said: "It is out of the question to put forward, three days from the Bundestag (lower house) vote, the issue of whether we should increase the fund... Let's not open Pandora's box on something that is a red flag for Germany."
The fund's status was bound to evolve but it was premature to say whether it might work "like an equity fund with a lever effect", Baroin added.
Merkel has been lobbying lawmakers intensively to ensure the government wins with its own majority without having to rely on the center-left opposition, which could destabilize the coalition and severely undermine her authority.
She said Germany would do everything it could to rebuild confidence in Greece, even though some ministers in her own cabinet have openly questioned the country's ability to avoid default and stay in the euro zone.
Merkel was to meet Greek Prime Minister George Papandreou on Tuesday evening after he promised German industrialists that Greece would meet its commitments under its EU/IMF bailout program despite missing key fiscal targets so far.
"I can guarantee that Greece will live up to all its commitments," Papandreou said.
The Greek parliament was due to approve a deeply unpopular new property tax later on Tuesday, one of several extra austerity measures the government is rushing through to plug a budget hole uncovered by EU/IMF inspectors earlier this month.
DAMAGE
Greek Finance Minister Evangelos Venizelos, back from tough talks with the International Monetary Fund, said speculation on default scenarios was harming his country and it was crucial to stick to the July 21 agreement on a second rescue for Greece.
In the latest such talk, German and French government economic advisers urged in a joint article on Tuesday that Greece be allowed to write off around 50 percent of its debt and called for support for banks with large Greek holdings.
Venizelos said the so-called troika of senior EU/IMF inspectors would return to Athens this week and Greece would receive the next 8 billion euro installment of aid in time to avoid bankruptcy next month. A source close to the team said they would probably return on Wednesday to complete a review of compliance with the bailout program.
Most analysts expect Greece to get the cash but default anyway within a few months, perhaps early next year.
European Central Bank board member Lorenzo Bini Smaghi fueled expectations of a larger bailout pool by saying on Monday that policymakers were working on "how to leverage the money out of the EFSF in a more innovative and efficient way".
Citing U.S. programs to rescue banks during the 2008-9 financial crisis, he said EFSF funds could be used as collateral to borrow from the central bank, making more money available for crisis fighting. His ECB colleague Ewald Nowotny also said an increase in the funds available was being discussed, though it might not be as high as some expected.
But German Bundesbank chief Jens Weidmann, the leading hawk on the ECB's governing council, poured scorn on such options, saying they would discourage politicians from taking tough decisions to cut budget deficits and weaken faith in the euro.
Credit ratings agency Standard & Poor's was quick to warn when talk of leveraging the EFSF first became public last week that such a move could potentially trigger ratings downgrades for leading euro zone countries Germany and France.
A senior EU official in Brussels said many ideas for how to leverage the rescue fund were being floated but it would take time to check the legality of such options and build political consensus in the 17-nation euro zone for any change.
"Nobody wants to talk about this before Thursday night," he said in a reference to the German parliament vote. "It cannot be discussed formally before the Bundestag (lower house) and maybe all other national parliaments have voted."
Slovak lawmakers will be last to vote on the widening of the EFSF's powers on October 11, leaving little time to agree on further measures before the bloc's next summit on October 17-18.
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