Insight: The day Europe lost patience with Britain

BRUSSELS (Reuters) - It was billed as a summit to save the euro. It may be remembered as the day Europe lost patience with Britain, as most of the continent threw its lot in with EU founding members France and Germany and committed to binding their economies ever more tightly.

There was plenty of talk of history in the making in the week before the Dec 8/9 gathering of European Union leaders - the eighth this year. But it was all about the currency and whether it would survive the strains of a debt crisis that over the past two years has engulfed Greece, spread to Ireland, Portugal, Spain and Italy and now threatens France and even mighty Germany.

As the summit began, there was no hint of the drama that was to come in the early hours of Friday, the moment when Europe split, 26 against one, after about 10 hours of talks. Britain has always had an uneasy relationship with its EU partners, choosing not to join the single currency or sign the open borders Schengen treaty and often kicking against what it sees as Brussels "interference."

But this was a low point. The first time in 39 years that a British prime minister had used a veto to block an EU agreement. David Cameron cast it is a bold and necessary decision to protect British interests. Most of the rest of Europe appeared to regard it as reckless and went a different way. Hours later, when the leaders briefly reconvened to finish their discussions, Cameron cut a lonely figure. French President Nicolas Sarkozy appeared to avoid an extended hand as Cameron walked to his seat.

The build up to this last summit of the year had been much like the previous seven. The language had been recognisable too, even if market pressures had added an unprecedented degree of urgency to glacial EU decision making. Overnight borrowing from the European Central Bank hit its highest level since March at the start of December, showing the degree of tension amongst banks.

PROFOUND CONCERN

U.S. Treasury Secretary Timothy Geithner had spent several days in Europe before the summit. The United States, like all of Europe's trade partners, had been watching the accelerating debt crisis with profound concern, worried for their own economies and banks.

In meetings with the head of the ECB, Mario Draghi, and euro zone finance ministers the conversation was all about the two-year-old debt crisis and how to resolve it. The issues: the role of the ECB, how far should or would it stand behind countries to buy them breathing space, the scale of the euro zone's rescue fund, the part to be played by the IMF, and should the EU let private bondholders off the hook.

Geithner spent time in Frankfurt, Berlin, Paris, Marseille and Milan. London didn't figure on his itinerary. During the same week, German Chancellor Angela Merkel and Sarkozy spoke frequently and met in person. There were contacts with Spain's incoming Prime Minister Mariano Rajoy. Draghi was closely involved in discussions at all stages, insiders say. Once more, Cameron was peripheral.

Immediately before the summit, the U.S. assessment of Europe's progress was, in broad terms, they know what they need to do but they need to work out how they're going to do it. As one U.S. official put it, fixing the flaws of the 13-year-old single currency - a monetary union without coordinated budget policy - could not happen overnight. But the Europeans were moving closer to addressing the problem at its root.

That assessment captured well the mood in the hours heading into the latest in a long line of "crunch" summits.

Germany - Europe's biggest economy - was intent on changing the European Union's treaty to enshrine stricter budget discipline and penalties for countries that failed to adhere to them, to ensure there could be no repeat of the current crisis. From the German perspective, only by reforming economies, cutting social benefits and working longer would the indebted members of the euro zone and the single currency emerge from the turmoil. Printing money would buy only a temporary respite and would remove the incentive to reform.

France was ready to back Germany in a push for full-blown treaty change, but really favoured the idea of an intergovernmental treaty - akin to a sideline agreement - among the 17 euro zone members, anchoring the single currency and its members at the heart of a new Europe.

NATIVITY PLAY

Britain's prime minister, under pressure from a sizeable anti-EU element in his own party, set off for the Brussels meeting straight from his son's school nativity play, having promised during a particularly raucous session of parliament the previous day that he would defend Britain's interests at the summit.

With hindsight, the choreography on the evening of Thursday, Dec 8 probably should have been clear to Cameron and everyone else.

Speaking a few hours before the summit began, European Commission President Jose Manuel Barroso issued this challenge to Europe's leaders: "What I expect from all heads of governments is that they don't come saying what they cannot do but what they will do for Europe."

Luxembourg Prime Minister Jean-Claude Juncker, who chairs euro zone finance ministers' meetings, was the first to arrive at the Brussels venue. Juncker said he preferred to see unanimity on treaty change among the 27, but if that wasn't possible, the 17 members of the euro zone would have to go it alone. "Their relationship is more intimate than between the 27."

When Cameron arrived in Brussels on Thursday it was after 6 p.m.. His first meeting was with Italy's new Prime Minister Mario Monti, an unelected "technocrat" charged with getting Italy's finances in order. Europe's fourth biggest economy has a debt to GDP ratio of 120 percent after years of stagnation under Silvio Berlusconi. The meeting was brief and was followed by 45 minutes of talks with Merkel and Sarkozy. Cameron was accompanied at that meeting by Foreign Secretary William Hague and Jon Cunliffe, the prime minister's most senior EU adviser, the architect of the rules that helped keep Britain out of the euro and Britain's next ambassador to the EU. One official who saw the three leaders emerge said they were "visibly tense."

BRITAIN'S ISOLATION

Then came dinner and the start of the meeting that was to end in Britain's isolation. Sources involved described how events unfolded. The intention was to get the 27 leaders to agree on what they wanted for a stronger euro zone first, and then work out how to achieve it, officials said. It was disagreement over the means, not the objective, that led to the break down.

An official present at the negotiations said Cameron had begun by saying that he understood there was a desire for treaty change, and that he wanted it too, but if Britain were to give its backing, it needed something in return. "His reasoning appeared to be: 'you want treaty change, I want treaty change', 'I need something because you are asking for something'," the official said, describing it as logic that wasn't going to fly.

At that point, the British prime minister set out two concessions he wanted in exchange for Britain's support on treaty change. "One was a safeguard on the internal market ... but that was not the problem," the official said. "Then he launched the idea on financial services."

Financial services account for about 10 percent of Britain's economy and the government has been at pains to shield the sector from regulation emanating in Brussels. Britain had shared the outlines of its thinking with some of its partners, officials said, but it hadn't circulated anything approaching a document sufficiently detailed to form the basis of discussion. For that reason, the demands were news to many of the people around the table. But it wasn't just the way Cameron went about it, it was the substance of the demands. He was effectively asking for a softening of regulation on Britain's financial sector at a time when many voters and politicians believe banks are largely to blame for the crisis Europe is suffering and want tighter regulation on the sector.

DEAD FROM THE START

"Politically speaking, when the banks are considered the enemy and the root of all the problems we have today, Cameron's arguments were the wrong arguments at the wrong time for the wrong people," the official said. "Politically, he was dead from the start."

At that point old enmities came into play, rooted in a widely-held French view that Britain never really belonged in the European Union in the first place. "The French were using all this as a really perfect alibi to get rid of the British. Sarkozy used the proposals of the British to justify an intergovernmental treaty," the official said, explaining that intentionally or otherwise, Cameron had played straight into Sarkozy's hands.

It may have appeared things couldn't get worse for the British prime minister, a relative novice on the EU stage.

"It took 10 or 20 minutes to see that most of the participants were not pleased at all with the idea of Britain getting an opt out or exceptional treatment for their financial services and it didn't fly at all. There was no understanding for it. David Cameron obtained nothing. Just nothing."

"We understand his domestic political situation. He is a prisoner of domestic constraints."

Another official present at the talks recalled the moment, in the early hours of Friday, when European Union President Herman Van Rompuy, who chaired the meeting, proposed moving forward with an intergovernmental agreement of the 17 euro zone nations, with an open invitation for other countries to join.

"France said yes, immediately followed by Germany and then one by one, in a matter of seconds the member states of the euro zone backed the Franco-German call. Within a few minutes, the non-euro zone member states decided they wanted to be in and left Cameron completely isolated. The swing was very, very quick. Everybody was on board in a matter of minutes. I think it was obvious inside the room that Cameron was shocked by the swiftness with which his allies left him alone."

"Cameron made a serious miscalculation. He genuinely thought he could get something back in return and underestimated the willingness of the euro zone to move on. That's our view. This deal has probably saved the euro, but all this will now have serious repercussions on the relationship between Britain and the EU." .

(additional reporting by Matt Falloon and Mark John in Brussels, Paul Carrel in Frankfurt, David Lawder in Washington; writing by Janet McBride; editing by David Stamp)

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Analysis: Cameron puts Britain offside and offshore in Europe

LONDON (Reuters) - David Cameron has put Britain offside and offshore in Europe.

In his failed last-minute quest for special treatment over financial regulation, the prime minister has taken Britain out of the room where decisions on the future of Europe will be shaped.

The consequence could well be a prolonged, bitter parting of the ways between the British and the rest of the European Union, culminating in an acrimonious divorce in which both sides lose.

The cheers of British Eurosceptics for Cameron's veto of EU treaty changes to allow the countries that share the euro single currency to pursue closer fiscal union were echoed by cries of "good riddance" in much of mainland Europe.

How this can safeguard the interests of the City of London financial centre is a mystery, not least to some of the bankers and executives whose much criticized sector accounts for 10 percent of the British economy.

"No matter what happens now, the UK has isolated itself and lost critical influence for no gain whatsoever," said Sony Kapoor, head of the Brussels economic think-tank Re-Define.

Britain is already seen by many as a free-rider, enjoying the benefits of being the euro zone's principal financial centre without the responsibilities of membership, while refusing to contribute to rescue packages for indebted countries.

The UK does pay a small share of loans to Greece and Portugal via the International Monetary Fund, and it lent money bilaterally to Ireland, a neighbor and big trade partner, but it is refused to pay into the euro zone's bailout fund.

Former U.S. ambassador to London Raymond Seitz wrote in his 1998 memoir "Over Here" that Britain's usefulness as an ally was directly linked to its clout in the EU. "If Britain's voice is less influential in Paris or, it is likely to be less influential in Washington."

If the country is perceived as being on its way out of the EU in the longer term due to the deepening hostility of Cameron's Conservatives and of public opinion, it will also be a less attractive investment destination.

As Tom Brown, a London-based senior executive with a German bank, wrote in a letter to Britain's Financial Times, "the talk of "safeguarding" the City misses the point, as the City can only maintain its ascendancy in financial services if the UK is a fully committed member of the European Union."

French President Nicolas Sarkozy said Cameron had picked the wrong time to seek special protection for bankers, hedge fund managers and tax shelters which citizens across Europe believed needed more regulation, not less, in the wake of the global financial crisis.

Sarkozy achieved a long-standing goal of French policy due to Cameron's stance, with the emergence of a hard core intergovernmental Europe centered on the euro zone with Britain on the outside.

Ironically, Kapoor noted, Britain is actually pursuing stricter rules for bank capital requirements, liquidity and the separation of retail banking from investment banking than the EU authorities are proposing.

Britain, home to roughly half the EU's financial services business, had sought veto rights over four areas of legislation, including on a European effort to curb so-called "gold plating" of community rules by adding tougher national standards.

In fact, Britain has never been outvoted on matters of financial regulation of interest to the City, EU officials say. It can usually count on allies such as Ireland, Sweden, the Netherlands and several central European states to help it block unwelcome legislation in embryo.

British-trained technocrats have played a central role in the European Commission's financial services unit, ensuring that EU directives take account of the concerns of the financial services industry from their drafting.

Indeed Brussels has often been criticized in continental Europe as too liberal on deregulation, especially under previous Internal Market Commissioner Charlie McCreevy of Ireland, whose personal motto was "regulate in haste, repent at leisure."

The current director-general for the Internal Market and Services, Jonathan Faull, a Briton, and was chosen partly to counterbalance Internal Market Commissioner Michel Barnier, a Frenchman regarded in London as hostile to the City.

Furthermore, the most influential European Parliament lawmaker on financial services is Malcolm Harbour, a British Conservative, chairman of the Committee on Internal Market and Consumer Protection. City lobbyists are omnipresent in the corridors of Brussels, with easy access to the Commission and the legislature.

Britain has not been voted down once by other EU states on any financial regulation issue since Barnier took over, opting for compromise instead. But experts say its ability to muster a blocking minority of allies was waning because of the political unpopularity of banks and hedge funds.

It recently failed to stop continental countries imposing a temporary ban on so-called naked short-selling of credit default swaps on sovereign debt -- selling insurance contracts on government debt without owning the underlying assets with the intention of buying them back at a lower price.

As Britain absorbed the shock of its near total isolation in Europe at the weekend, Chancellor of the Exchequer (finance minister) George Osborne denied that London has lost influence.

"We have protected Britain's financial services and manufacturing companies that need to be able to trade their products into Europe from the development of euro zone integration spilling over and affecting non-euro members of the EU," he said.

Such confidence appears to be based on the assumption that other European countries will be unable to use the core EU institutions - the Commission and the European Court of Justice - to enforce their own agreements without Britain's consent.

That may be tested both politically and in the courts. With at least 23 and perhaps 26 of the 27 EU members forging ahead with a separate fiscal union treaty soon, they will want to use existing EU institutions rather than duplicating them.

They may also seek to handle issues such as banking resolution and deposit guarantees inside the euro zone in future.

Economist Nicolas Veron of the Bruegel think-tank argues that some of this could be done without treaty change, for example providing supranational guarantees to national deposit insurance schemes, to forestall the risk of catastrophic retail bank runs in troubled countries.

So while there is no imminent threat to the free movement of capital or goods in the single market, the result of Cameron's veto may well be to hasten a tightening of financial regulation inside the euro zone to the detriment of the City.

(Writing by Paul Taylor; editing by Philippa Fletcher)

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Europe ramps up rescue fund, may turn to IMF

BRUSSELS/MILAN (Reuters) - Euro zone ministers agreed on Tuesday to ramp up the firepower of their rescue fund but couldn't say by how much and raised the possibility of asking the IMF for more help after Italy's borrowing costs hit a euro lifetime high of nearly 8 percent.

Two years into Europe's sovereign debt crisis, investors are fleeing the euro zone bond market, European banks are dumping government debt, deposits are draining from south European banks and a looming recession is aggravating the pain, fuelling doubts about the survival of the single currency.

The 17 ministers agreed on a detailed plan to insure the first 20-30 percent of new bond issues for countries having funding difficulties and create co-investment funds to attract foreign investors to buy euro zone government bonds.

Both schemes would be operational by January with about 250 billion euros from the euro zone's EFSF bailout fund available to leverage after funding a second rescue program for Greece, Eurogroup chairman Jean-Claude Juncker said.

The aim was for the International Monetary Fund to match and support the new firepower of the European Financial Stability Facility, Juncker told a news conference.

"We also agreed to rapidly explore an increase of the resources of the IMF through bilateral loans, following the mandate from the G20 Cannes summit, so that the IMF could adequately match the new firepower of the EFSF and cooperate even more closely," he said.

But with China and other major sovereign funds reticent about investing more in euro zone debt, EFSF chief Klaus Regling said he did not expect investors to commit major amounts to the leveraging options in the next days or weeks, and he said he couldn't put a figure on the final size of the leveraged fund.

"It is really not possible to give one number for leveraging because it is a process. We will not give out a hundred billion next month, we will need money as we go along," he said.

Italy had to offer a record 7.89 percent yield to sell 3-year bonds, a stunning leap from the 4.93 percent it paid in late October, and 7.56 percent for 10-year bonds, compared with 6.06 percent at that time.

The European Commission's top economic official, Olli Rehn, said Prime Minister Mario Monti's new government would have to take extra deficit cutting measures beyond an austerity plan already adopted to meet its balance budget promise in 2013.

The Italian yields were above the levels at which Greece, Ireland and Portugal were forced to apply for international bailouts, but European stocks and the euro held their ground in apparent relief at the strong demand, with the maximum 7.5 billion euros sold.

French Prime Minister Francois Fillon dismissed a report in business daily La Tribune that ratings agency Standard & Poor's would lower its outlook on France's AAA credit rating to negative within 10 days as "nonsense."

Such a move would deal a severe body blow to the euro zone's ability to rescue heavily indebted countries.

LOOKING TO IMF IF EFSF FALLS SHORT

The Eurogroup ministers agreed to release their portion of an 8 billion euro aid payment to Greece, the 6th installment of 110 billion euros of EU/IMF loans agreed last year and necessary to help Athens stave off the immediate threat of default.

Juncker said the money would be released by mid-December, once the IMF signs off on its portion early next month.

With Regling unable to put a single figure on the scaled up EFSF, which EU leaders had hoped would reach 1 trillion euros, finance ministers said the IMF may have to provide more help, possibly bolstered with European money.

"We will have to look at the IMF which can also make available additional funds for the emergency fund. I think countries in Europe and outside of Europe should be prepared to give more money to the IMF," Dutch Finance Minister Jan Kees de Jager told reporters.

"We have talked about leverage though private money, but it would be two or two and a half times an increase so not sufficient and we have to look for other solutions to compliment the EFSF and that in my mind will be the IMF," he said.

With Germany opposed to the idea of the European Central Bank providing liquidity to the EFSF or acting as a lender of last resort, the euro zone needs a way of calming markets.

The ECB shows no sign yet of responding to widespread calls to massively increase its bond-buying.

One option EU sources said is being is explored is for euro system central banks to lend to the IMF so it can in turn lend to Italy and Spain while applying IMF borrowing conditions.

"We will discuss with the ECB. The ECB is an independent institution, so we will put on the table some proposals and after that it is for the ECB to take the decision," Belgian Finance Minister Didier Reynders told reporters.

The ECB failed for the first time since May to fully offset 203.5 billion euros in euro zone government bond purchases, adding to fears that the debt crisis is ratcheting up stress on the bloc's banking sector.

A Reuters poll of economists showed a 40 percent chance of the ECB stepping up bond-buying with freshly created money within six months, something it has opposed.

The poll forecast a 60 percent chance of an ECB rate cut to 1.0 percent next week and a big majority of economists said they expect the central bank to announce new long-term liquidity tenders to help keep banks afloat at its December 8 meeting.

MONTI TO UNVEIL HIS PLANS

Monti outlined his fiscal and economic reform plans to the euro zone ministers amid reports, officially denied in Rome and Washington, that Rome has held preliminary discussions with the IMF on financial support.

Italy has debts of 1.9 trillion euros - equivalent to 120 percent of national output - and needs to refinance some 340 billion euros of maturing debt next year with big redemptions starting in late January. Tuesday's auction suggested it will struggle to keep borrowing costs under control without help.

Most analysts say the ECB will have to intervene more decisively on bond markets and the euro zone will have to agree eventually to issue common bonds, but Germany opposes both.

Berlin has pinned its efforts on a drive for closer fiscal integration among euro zone members.

Chancellor Angela Merkel told lawmakers she would not make a deal at a December 9 European Union summit to drop resistance to joint euro zone bonds in exchange for progress on strengthening fiscal rules, MPs quoted her as saying.

She told a closed-door meeting Europe was "a long way from euro bonds," suggesting they may not be ruled out forever.

For now, Germany and France are pressing for coercive powers to reject euro zone members' budgets that breach EU rules, alarming some smaller nations who fear the plans by-pass mechanisms for ensuring equal treatment.

Berlin and Paris aim to outline proposals for a fiscal union before the EU summit that is increasingly seen by investors as a last chance to avert a breakdown of the single currency area.

(Additional reporting by Marius Zaharia in London, Erik Kirschbaum in Berlin, Cecile Lefort in Sydney, Robin Emmott and John O'Donnell in Brussels; Writing by Paul Taylor/Mike Peacock)

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