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European finance ministers have been warned confidentially of the danger of a renewed credit crunch as a "systemic" crisis in euro zone sovereign debt spills over to banks, according to documents obtained by Reuters on Wednesday.
In a report prepared for ministers meeting in Poland on Friday and Saturday, senior EU officials said the 17-nation currency area faces a "risk of a vicious circle between sovereign debt, bank funding and negative growth."
"While tensions in sovereign debt markets have intensified and bank funding risks have increased over the summer, contagion has spread across markets and countries and the crisis has become systemic," the influential Economic and Financial Committee said.
"A further reinforcement of bank resources is advisable," ministers were told in language that echoed an International Monetary Fund call for urgent action to recapitalize European banks.
The report highlighted European policymakers' challenge to restore confidence as the leaders of Germany, France and Greece held a crucial conference call on efforts to avert a Greek default that could cause a global financial shock.
Moody's Investors Service downgraded two of France's top banks, Societe Generale and Credit Agricole, saying its concerns about their funding and liquidity profiles had increased in the light of worsening refinancing conditions.
The ratings agency left France's largest bank, BNP Paribas, on review, saying its profitability and capital base gave it an adequate cushion to support its Greek, Portuguese and Irish exposure.
The euro and European stocks were earlier boosted by an announcement by the head of the European Commission that the EU executive would soon present options for issuing a common euro zone bond, despite fierce resistance in Germany.
Many investors see joint debt issuance as the best way out since it would reassure markets that Europe's strongest economies were taking responsibility for weaker states.
But there is strong political opposition in northern Europe to underwriting the debts of what are seen as profligate southern states, making euro bonds a distant prospect.
European Commission President Jose Manuel Barro Finance Ministry spokesman reaffirmed Berlin's opposition to the idea but said it awaited the proposals.
STOP CRISIS SPREADING
China and the United States both voiced concern that euro zone governments may be losing control of the debt crisis.
Chinese Premier Wen Jiabao said Beijing was willing to help its biggest trading partner, but added that Europe must stop the crisis -- which now threatens Italy -- from growing.
"What we have to take note of now is to prevent the sovereign debt crises from spreading and expanding further," Wen said on Wednesday in an apparent response to pleas to buy more euro zone government bonds.
Chinese state media said the EU should recognize Beijing's help with the debt crisis by giving China market economy status, which would give better protection against European anti-dumping penalties -- a major irritant.
A senior Indian official said finance ministers of Brazil, Russia, India, China and South Africa would discuss a Brazilian proposal to increase their holdings of euro zone bonds when they meet in Washington on Sept. 22.
But Greece's deputy finance minister injected a note of skepticism, saying those countries had shown little or no interest in buying short-term Greek debt despite invitations to do so.
Credit markets are factoring in a 90-percent chance Greece will default on its debts and they demanded the highest risk premium on Italian five-year bonds at auction on Tuesday since the country joined the euro.
Italian Prime Minister Silvio Berlusconi's government won a parliamentary confidence vote on a 54-billion-euro austerity package. The moves have done little so far to stem doubts about whether the euro area's third-biggest economy can manage its debts.
Greece, Ireland and Portugal have all received EU/IMF rescue packages, but many see Italy as too big to bail out.
BNP Paribas announced a plan to sell 70 billion euros in assets to help ease investor fears about leverage and funding that hit its two main rivals.
Bank of France Governor Christian Noyer said the Moody's action on French banks was relatively good news, noting it put them on a par with other major European lenders regarded as healthy such as HSBC, Barclays and Deutsche Bank.
"It's a very small downgrade and Moody's had a higher rating than the other agencies so it's just put them on the same level or slightly better than the others," Noyer said.
Some analysts and industrialists say a combination of a Greek default and a financial meltdown in Italy could engender a banking crisis akin to the 2007-8 global credit crunch and risk tearing the euro zone apart.
Greece has said it will run out of cash within weeks unless it gets the next 8 billion euro aid tranche in October to pay wages and pensions.
In a measure of Washington's concern, Geithner will attend the meeting of EU finance ministers in Poland on Friday -- his second trip to Europe in a week.
Geithner tried to shore up confidence in Europe's ability to solve the crisis, telling CNBC television the strongest euro zone states have the financial capacity to hold the currency area together.
"There is no chance that the major countries of Europe will let their institutions be at risk in the eyes of the market," he said, adding the United States had an interest in seeing the crisis resolved because it was causing economic uncertainty.
Two unidentified banks tapped the European Central Bank for dollar funding on Wednesday in the latest sign of stress as U.S. money market funds and other traditional dollar providers cut back on lending to Europe.