IN THE WEEK AHEAD

IN THE WEEK AHEAD: Investors will have only a few U.S. economic reports to distract them from the events in Europe. Factory orders and an update from the service sector will be followed by monthly updates on consumer credit and sentiment. Investors will focus on the European summit in Brussels at the end of the week. Yes, we are still talking about Europe. Fiscal union and tighter controls will be the main topics, as the wealthier nations (read: Germany) try to extract a pound of flesh in exchange for a full-fledged bailout of weaker nations. Economists have been saying that to solve the European crisis, Germany would have to come down from its moral high horse and admit it has far too much to lose if the EU were to implode. Last week, Merkel's comments, along with the central bank action, were seen as positive developments towards that end. To wit, stocks were up 7 percent, the strongest weekly performance since 2009. German government bonds, which until recently had been a haven from turmoil in the rest of the euro zone, are losing their allure as the sovereign-debt crisis roils Europe. For most of the two years since Greece's budget woes set off a spiral of selling in the bond markets of some euro-zone countries, German bonds, known as bounds, have benefited from a flight to safety along with Treasury bonds and U.K. gilts. But that relationship started to crack a few weeks ago when Germany had its worst 10-year bond auction in history, which sparked one of the biggest sell offs in some time. Despite the brouhaha about the U.S. jobs report (more on that below), the stock market-moving news last week was all about Europe and the coordinated central bank action to attack one of the symptoms of the European contagion --liquidity for European banks. Sure, the action could be called a "band-aid," but it could also be seen as the necessary preparation for the major procedure that is required to treat the ailing patient.

A summit of leaders on Feb. 4 produced no breakthrough, with Germany and France introducing new proposals for boosting competitiveness across the zone, prompting renewed disagreement among states. Another summit is due to be held after March 9 to sustain momentum towards a deal, with the complete package expected to be finalised at another summit on March 24-25 in Brussels. Below are ideas that have been discussed formally or informally and could be included. Some measures face strong opposition from Germany and appear unlikely to make it.

INCREASING THE EFFECTIVE LENDING CAPACITY OF THE EFSF

There is a strong chance of this step being adopted. The nominal lending capacity of the European Financial Stability Facility, the euro zone bailout fund, is 440 billion euros, but because of a system of guarantees to secure a triple-A credit rating, the special purpose vehicle has an effective lending capacity of only around 250 billion euros. The European Commission, France, Germany and others agree that the effective lending capacity should be boosted to the full 440 billion and talks are focusing on how to do that. The idea of raising the EFSF's overall size above 440 billion euros was rejected by euro zone ministers on Jan. 17.

HOW COULD THE EFSF'S CAPACITY BE INCREASED?

Lifting the EFSF's effective capacity could require euro zone states to increase their guarantees, forcing some governments to seek fresh approval from their parliaments. This could be politically tricky in countries such as Germany where public opinion is against bailouts of countries that have been overspending or not kept budgets in check. Berlin has indicated that instead, euro zone countries with a rating below the top notch could inject cash into the EFSF, making up for their lack of a triple-A grade. If the 11 non-AAA countries in the euro zone injected cash, the fund would no longer need cash buffers to secure its rating and could therefore lower its interest rate. But non-AAA countries are not keen to spend cash, so the end-result could be a mix of both options, euro zone sources have indicated.

Five cajas failed Europe-wide stress tests on banks last year. The Bank of Spain has forced them into a round of mergers, reducing their number from 45 to 17 last year. High levels of bad property loans at the cajas are seen as a major risk for Spain as it slashes its budget deficit to stave off fears it will need an Irish or Greek-style rescue from the European Union and International Monetary Fund. Estimates of the cost of recapitalising the savings banks range from €17bn (£14.4bn) to €120bn, with consensus falling in the €25bn to €50bn range, according to Reuters. Economists say Spain could afford that level of rescue without seeking outside aid.The banking sector has so far set aside €88bn to cover losses on total loans of €439bn to real estate and construction. Spain's borrowing costs have soared amid worries that the sovereign debt crisis that forced Greece and Ireland to seek bailouts will spread to Portugal and then Spain. A budget deficit of 9.3% of GDP in 2010 and stagnant growth have added to the worries, though the government is hitting deficit reduction targets and pledges pension and labour reform shortly. Analysts welcomed the promise of caja recapitalisation. "This underpins hopes that Spain is now on the right track," Commerzbank strategist David Schnautz told Reuters.