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The rescue of Dexia, which has global credit risk exposure of $700 billion -- more than twice Greece's GDP -- came as the leaders of French and Germany agreed in a joint press conference that European banks needed to be recapitalised, but papered over differences on how that would happen.

Details of the rescue were not revealed while Dexia's board met in Brussels to approve the plan, but it will call for the bank's Belgian retail unit and French municipal finance operations to come under government control.

Dexia was forced to seek state help for the second time in three years after a liquidity crunch hobbled the lender and sent its shares down 42 percent over the past week.

French Prime Minister Francois Fillon, his Belgian counterpart Yves Leterme and Luc Frieden, the finance minister of Luxembourg, where Dexia has a large presence, had found a solution for the stricken Franco-Belgian bank, Leterme's office said early Sunday afternoon.

"The three governments have agreed to put a proposal to the board which fits completely with the goals of the Belgian government, which means to take over Dexia Bank Belgium, secure it and turn it into a very safe bank," Leterme said after two hours of talks at Egmont Palace in Brussels -- also the site of negotiations for a previous Dexia rescue in 2008.

At stake in the talks is how much each government will have to contribute to help wind down Dexia, a thorny subject given that Belgium and France are already struggling to contain large deficits.

The need to recapitalise banks is emerging as another strain for European governments whose budgets are already stretched. Belgium had a debt-to-gross domestic product ratio of 96.2 percent last year, lower only than Greece and Italy among euro zone members and on a par with bailout recipient Ireland.

"I am convinced that it is possible ... by tomorrow morning to have an agreement in which Belgium resolves the issue without pushing up the debt level of our country too high," Leterme told Belgian television before Sunday's talks.

The burden of bailing out Dexia led ratings agency Moody's to warn Belgium late on Friday that its Aa1 government bond ratings may fall.

Dexia, which used short-term funding to finance long-term lendings, has found credit drying up as the euro zone debt crisis worsened. This problem has been exacerbated by the bank's heavy exposure to Greece.

Dexia's near collapse stoked investors' anxieties about the strength of European banks and coincided with growing talk about coordinated EU action to recapitalise banks across the continent.

Germany and France have so far been split over how to recapitalise shaky European banks. Paris wants to tap the euro zone's 440 billion euro ($594 billion) European Financial Stability Facility (EFSF) to recapitalise French banks, while Berlin is insisting the fund should be used as a last resort.

There were fresh reports over the weekend that France's top banks BNP Paribas and Societe Generale could agree to capital injections as part of a Europe-wide plan to boost lenders' financial strength, although both banks continue to deny such plans.

Dexia's overhaul will likely see its French municipal financing arm split from the group and merged with French state bank Caisse des Depots and Banque Postale, the French post office's banking arm.

The Belgian government will nationalise Dexia's largely retail banking business in Belgium. Media reports said it would have to pay 4 billion euros to do so.

Healthy units, such as Denizbank in Turkey, will be sold.

A 'bad bank' supported by state guarantees will hold 95 billion euros in bonds, including 12 billion euros of sovereign debt of weaker euro zone periphery nations.

Including 7 billion euros of securities linked to U.S. mortgages, France and Belgium may need to provide guarantees to cover up to 200 billion euros of assets, which would be more than 55 percent of Belgian GDP. Belgium, under an agreement reached between the governments on Sunday, will guarantee 60 percent of the bad assets while France will be responsible for most of the rest, sources familiar with the talks said.

The key issues are how to divide up the 'bad bank' asset guarantees, how much Belgium should pay to nationalise Dexia's Belgian banking business and whether others, such as Belgium's regions, would be involved in its purchase.

Dexia's shares have been suspended since Thursday afternoon..

(Writing by Marie Maitre, Christian Plumb and Philip Blenkinsop; Additional reporting by Sophie Sassard; Editing by Hans-Juergen Peters, Sebastian Moffett and Richard Chang)

Chengdu, the capital of southwestern Sichuan province, answered the call for stimulus action with a bold plan for a railway hub modeled after Waterloo railway station in London.

Except London's Waterloo was not ambitious enough.

"I was shocked when I finally got to visit Waterloo. It was so small," said Chen Jun, a director at Chengdu Communications Investment Group, which built the new Chinese terminal. "I realized we would probably need a station a few times bigger to meet the demands of our city."

In a manner typical of many infrastructure projects in China, Chengdu more than doubled the size of its planned transport hub, borrowed 3 billion yuan ($473 million) from a state bank to finance it, then set out on a blistering construction timeline that saw the finishing touches put on the project two years later.

But instead of getting the accolades they expected for helping to stimulate the economy, Chengdu Communications and many of China's 10,000 local government financing vehicles (LGFV) have now come under a harsh spotlight for the grim side-effects of the construction binge.

China's local governments have piled up a mountain of bad debt, some of it to finance bridges to nowhere and other white elephant projects, which now threatens to constrict growth at a time when the global economy is sputtering. It is adding to other systemic risks in China, including a sharp downturn in the property market and a rapid rise in problematic loans.

Local governments had amassed 10.7 trillion yuan in debt at the end of 2010. The government expects 2.5 to 3 trillion yuan of that will turn sour, while Standard and Chartered reckons as much as 8 to 9 trillion yuan will not be repaid -- or about $1.2 trillion to $1.4 trillion.

In other words, the potential debt defaults could be even larger than the $700 billion U.S. bail-out programme during the 2008 crisis.

Reuters reported in mid-year the government was working on a relief plan for local governments, including allowing them to tap the municipal bond market for the first time as an alternative to bank loans, which are becoming harder to get.

The risks of default are rising. Nearly 85 percent of the local government finance vehicle loans in northeast Liaoning province, for instance, missed debt service payments in 2010, an audit report posted on the Liaoning Daily website said.

But in visits and interviews at city-run vehicles around China, officials appeared unworried. They say they were only following Beijing's directives to keep growth on track, and the central government would surely step in to bail them out.

Perhaps their complacency is justified. Beijing, which holds more than $3 trillion in foreign exchange reserves, certainly has the resources to rescue them, and has done so in the past -- it set up asset management companies to help China's top banks clean up mountains of bad loans in the late 1990s.

But China is also vulnerable to a global downturn, and would need every piece of its economy performing well to avoid a serious slump. The infrastructure boom insulated the economy from a collapse in exports in 2008. Beijing has less firepower now. Inflation is uncomfortably high, and dumping more money into the economy would only make things worse.

Barclays Capital has predicted a global recession would trigger a "hard landing" in China, with gross domestic product sinking well below the 8 percent mark seen as the minimum for assuring enough job creation to keep up with urban migration.

A severe economic slump would depress land sales, a vital source of funding for local governments, and make their debt load even more precarious.

BUBBLE-SOME PROPERTY

In Chengdu, Chen leans back on a sofa in his office, smiles and readily concedes Chengdu will have big problems covering the bills for its version of the Waterloo train station.

"We're still unable to reflect on our accounts the problems that may arise from our investments into Chengdu's railroads," Chen said. "What happens next is that we may face some trouble repaying our loans when many of them come due."

Chengdu Communications had liabilities of 18.9 billion yuan at the end of 2010 against current assets valued at 11.7 billion yuan.

Chen is not unduly concerned. He thinks he has a solution, one local governments across China have also grasped: Real estate. Chen, the chairman of six other state companies in the city, intends to build huge residential and commercial projects around stations such as Waterloo -- with borrowed money, of course.

The problem with that idea is that Beijing has been taking increasingly urgent steps to halt a speculative property boom and has told state banks to cut lending. Domestic investment -- much of it in property and infrastructure development -- accounted for 70 percent of China's gross domestic product last year, a far bigger share than in developed economies.

According to the McKinsey Global Institute, the proportion of China's total debt to gross domestic product was 159 percent at the end of 2008, before it began the massive stimulus programme that has racked up piles of local government debt.

Local governments have long had to tap other sources of income to supplement their meager share of the country's taxes. Beijing controls the bulk of tax revenues to prevent local officials from spending wastefully, and as a way of redistributing wealth between poor and rich provinces.

So they raise money by selling or taxing property or borrowing money. They are barred from borrowing directly from banks as government entities, however, hence the proliferation of their financing vehicles.

Local officials have a strong interest in keeping property prices high, since it is a key source of revenue. China Real Estate Information Corp., a Shanghai-based property information and consulting firm, estimates 40 percent of local government revenue came from land sales last year. Land also is often used as collateral backing the loans to their financing vehicles.

So throughout China, a building boom financed with massive bank borrowing is being securitized by land prices that local governments fervently hope will stay high, even as Beijing tries to tamp them down.

"The underlying problem here is that local governments have a lot of expenditure mandates for infrastructure, for social services, and they don't have enough regular revenue to cover it," says economist Arthur Kroeber.

BRIDGE FINANCING

Wuhan, capital of central Hubei province, is known as one of China's "four ovens", cities where summertime temperatures can soar to 40 degrees Celsius. Its strategic location at the intersection of the Yangtze and Han rivers has made it a major transportation hub and in the past three years the city has been feverishly building bridges, railways and expressways.

Wuhan Urban Construction Investment and Development Co., the vehicle set up to finance much of this infrastructure, had taken out 68.5 billion yuan in bank loans as of September 2010, a sum far in excess of its operating cash flow of 148 million yuan.

Perhaps for that reason, city officials found a novel if unpopular way to pay for the three new bridges they have built across the Yangtze, adding to the seven already spanning the world's third-longest river after the Amazon and Nile.

Besides the usual bridge tolls, Wuhan requires residents with cars to cross them at least 18 days a month, at 16 yuan a round trip.

The city of 9.8 million is expanding its subway system by adding another 215 km of track by 2017, with financing coming from big state-owned banks. Like other cities, Wuhan is counting on land sales and to secure the loans. Its land authority says land prices for high-end residential property have more than doubled since 2004 to 11,635 yuan per square meter today, despite a proliferation of housing developments.

For that reason, investment bank Credit Suisse called Wuhan one of China's "top 10 cities to avoid", warning in a report this year it would take eight years to sell off its existing housing stock, let alone the tens of thousands under construction.

Wuhan Urban Construction Investment and Development is the largest government financing vehicle in the city, employing 16,000 workers and sitting atop total assets of 120 billion yuan.

Despite its debt woes, Shen Zhizhong, a deputy director at the vehicle's media office, argued his firm should not be blamed for the profusion of red ink.

"What we do is all decided by the government. We don't have any project that belongs to us," Shen said, adding it was "unscientific" to ask his company how Wuhan plans to pay off its debt. "We are like a sportsman, not a coach or a referee. How can you ask a sportsman something only known by a coach or a referee?"

After building the roads, railways and bridges that China said were so desperately needed just a few years ago, the financing vehicles now resent being made scapegoats for the mounting risk in the financial system.

NO WORRIES

Chengdu and Wuhan officials insist their own books are fine; the problem lies elsewhere.

Zeng Mingyou, head of Chengdu's economic planning department, said despite a mounting debt load the city was controlling expenses and managing risks.

"What is important is that we have risk control measures in place," said "Compared to other cities, Chengdu has very good controls in place."

The Chengdu government began reining in its financing vehicles about three years ago after it discovered highways were being built across farmland where there was no traffic, Zeng said.

He also said the city had stopped using land as collateral for infrastructure loans. "We can't be taking all our land and using it to back up loans," Zeng said. "At some point we'll run out of land. This is why the focus now is on sustainable development."

In Wuhan, Xie Zuohuai, deputy director of the media office at the Wuhan branch of China's bank regulator, said his city, too, was exemplary when it comes to managing its debt.

"Wuhan is a model city in implementing Beijing's rules of regulating local government debt," he said in between lighting up cigarettes and stubbing them out in an overflowing ashtray. "I'm confident the central government will successfully manage risks," Xie added, echoing a widespread perception that Beijing will come to their rescue if need be.

Any wave of defaults big enough to destabilise major banks or crimp the government's finances could have consequences not only for China's economy, but for global growth and financial markets as well.

That risk appears to be pretty low for now, given the strength of bank balance sheets. The banking system has a bad loan coverage ratio at the end of 2010 of 218 percent to cover any losses, up from 80 percent at the end of 2008 and 155 percent at the end of 2009.

Despite that strengthened treasure chest, bank executives in Beijing, Wuhan and Chengdu say they have stopped lending to local governments entirely, unless their projects have some guarantee of profitability or are too big and costly to scrap.

"Right now, most banks have cut off new loans to local government financing firms," said a senior executive at a medium-sized bank in Beijing, who declined to be named because he was not authorised to speak on the matter.

The cities and financing vehicles themselves say credit is harder to come by.

"What the banks want to see now is a clear revenue stream," said Chen at Chengdu Communications. "Loans for big projects like highways and railroads are now harder to get."

For that reason, Chengdu Communications has become one the city's biggest operators of petrol stations, and Chen says he has so far faced no problems trying to get a bank to finance new ones.

SHADOW BANKING

Local officials need to keep their economies humming because they largely earn their Communist Party stripes with projects that boost employment and growth. With the loan spigots being turned off to rein in bubbly property prices, they face the prospect of housing projects grinding to a halt.

Enter the "shadow bankers". These are the underground lenders and trust companies who extend credit to people and companies that may not qualify for loans otherwise. They then slice and dice those loans into investment packages, akin to what American banks did with sub-prime mortgages for much of the past decade.

Credit Suisse last week described the burgeoning growth of informal lending as a "time bomb" that posed a bigger risk to the Chinese economy than even the local government debt pileup.

Credit Suisse estimated the size of China's informal lending at up to 4 trillion yuan, equivalent to around 8 percent of above-board bank lending. Interest rates on these loans runs as high as 70 percent and they are expanding at an annual rate of about 50 percent.

The shadow bankers have lent 208 billion yuan to real estate developers so far this year, nearly as much as formal bank lending of 211 billion yuan. The risks, analysts say, is that even healthy developers become vulnerable to a liquidity crisis, given the short tenor and high rates of these loans.

Formal banks have transferred some risky loans off their balance sheets to the shadow banking industry. As a result, Fitch Ratings has warned, lending has not slowed down as much as official data suggests -- and as Beijing would like.

Official banks have also been restructuring and reclassifying loans to dress up their books, analysts said. For example, they now get to classify local government borrowings as corporate loans, which allows them to set aside less in provisions and thus add to their quarterly earnings. According to Chinese media reports, banks plan to reclassify 2.8 trillion yuan worth of loans.

"Banks have to admit to some NPLs (non-performing loans), but they don't want to admit it because regulators are allowing them to restructure these loans," said Victor Shih, a professor at Northwestern University in Chicago who has written a book on China's financial system.

"This is unlike the late 1990s when the government forced the banks to admit to a huge amount of non-performing loans. This time round, the strategy is just to not admit to NPLs."

Such an arrangement appears to suit everyone. Beijing wants to keep the financial system from becoming destabilised, especially given the financial sector crises in the West. And local officials are keen to keep growth strong in the run-up to a critical Communist Party Congress next fall, when Party chief and President Hu Jintao is expected to hand power to younger leaders headed by the anointed next leader, Xi Jinping.

Whether they will also hand over a looming financial crisis to him as well remains to be seen.

(Additional reporting by Koh Gui Qing; editing by Brian Rhoads and Bill Tarrant)

With the turmoil threatening to spiral into financial meltdown as the value of banks' sovereign bond holdings slide, Merkel and Sarkozy are likely to discuss in Berlin both how to manage Greece, prevent contagion and strengthen lenders.

The implosion of Belgian lender Dexia, the first victim of the crisis, has added a sense of urgency to the talks. The French and Belgian prime ministers are set to finalize the break-up on Sunday.

"Dexia will be among the topics that will be discussed but the main topic is Greece and the euro zone, as banks are only a consequence" of the crisis, a source at the French finance ministry told Reuters.

Sarkozy is due to arrive in Berlin late on Sunday afternoon and hold a meeting with Merkel followed by a working dinner. A news conference will take place at 1430 GMT.

Talks are continuing over a vital aid tranche for Greece, which could run out of cash as soon as mid-November. European finance ministers are considering making banks take bigger losses on Greek debt -- an issue that could be discussed at the Merkel-Sarkozy meeting.

"It is possible that we assumed in July a level of debt reduction that was too low," German Finance Minister Wolfgang Schaeuble was cited as saying by a newspaper on Sunday.

"There is a high risk that this crisis further escalates and broadens," he added.

BOLSTERING BANKS

Germany and France have so far been split over how to recapitalize Europe's banks, which Ireland estimated on Saturday may need more than 100 billion euros ($135 billion) to withstand the sovereign debt crisis, while the International Monetary Fund (IMF) has said the banks need 200 billion in additional funds.

Paris wants to tap the euro zone's 440 billion European Financial Stability Facility (EFSF) to recapitalize its own banks, while Berlin is insisting the fund should be used as a last resort.

Qatar is being cited by some media as a potential savior for European banks yet analysts believe tiny Gulf Arab state is an unlikely white knight, as Europe's needs are too great.

Another key dispute is how to use the EFSF to buy sovereign debt to prevent contagion of the crisis, particularly crucial if Greece fails to secure its next aid tranche.

France does not want to set guidelines for the EFSF on the matter, whereas Germany wants to limit the sum used for each member state and set a time limit for bond purchasing.

"Given that the EFSF is limited overall, it makes sense also to limit the purchases on the secondary market for each country," Michael Meister, deputy parliamentary leader of Merkel's conservatives, told Reuters.

There was a danger, otherwise, the funds could be quickly used up, he said.

Berlin could be prepared to allow a more flexible use of the EFSF to prop up states and banks if Paris agrees to a broad haircut on Greek debt, a German paper wrote on Sunday.

But a government source told Reuters: "There is no such agreement." Furthermore, Merkel warned last Tuesday that the threat of contagion from a euro zone country rescheduling its debt would be huge, and it only made sense once it had achieved a primary surplus again.

The two euro zone heavyweights have come under pressure worldwide to resolve Europe's crisis which is roiling markets. U.S. President Barack Obama on Thursday urged Europe to "act fast," calling the common currency bloc's crisis the largest obstacle to the United States' own recovery.

World Bank President Robert Zoellick told Wirtschaftswoche magazine there was a "total lack" of vision in Europe and Germany in particular needed to show more leadership.

Merkel will visit Vietnam and Mongolia this coming week.

(Additional reporting by Andreas Rinke in Berlin and Regan Doherty in Doha, Editing by Hans-Juergen Peters)

The board of Dexia is due to meet in Brussels at 1300 GMT to seal the dismantling of the Franco-Belgian lender, which has global credit risk exposure of $700 billion, more than twice the size of Greece's gross domestic product.

Dexia, the first bank to fall victim to the euro zone sovereign debt crisis, was forced to seek government help this week after a liquidity crunch hobbled the lender and sent its shares into a tailspin.

Belgian caretaker Prime Minister Yves Leterme told a news conference on Saturday evening that final negotiations between France and Belgium would take place in Brussels on Sunday.

Leterme and his French counterpart Francois Fillon will both attend the final discussions, a government spokesman said, adding that a delegation from Luxembourg -- where Dexia had large operations -- would also take part in the meeting.

Dexia's near collapse stoked investors' anxieties about the strength of European banks and coincided with growing talk about coordinated EU action to recapitalize banks across the continent.

French President Nicolas Sarkozy was due to meet German Chancellor Angela Merkel on Sunday in Berlin to thrash out differences on how to use the euro zone's financial firepower to salve a sovereign debt crisis that threatens the global economy.

Germany and France have so far been split over how to recapitalize shaky European banks. Paris wants to tap the euro zone's 440 billion euro ($594 billion) European Financial Stability Facility (EFSF) to recapitalize French banks, while Berlin is insisting the fund should be used as a last resort.

Some investors view the response to Dexia's woes as a test of European governments' ability to take decisive action to rescue banks if the euro zone debt crisis worsens.

The burden of bailing out Dexia led ratings agency Moody's to warn Belgium late on Friday that its Aa1 government bond ratings may fall.

Dexia, which needs short-term funding to finance long-term lendings, has found credit drying up as the euro zone debt crisis worsened, and this situation has been exacerbated by the bank's heavy exposure to Greece.

Dexia's overhaul will see its French municipal financing arm split from the group and merged with French state bank Caisse des Depots and Banque Postale, the French post office's banking arm.

The Belgian government wants to nationalize Dexia's largely retail banking business in Belgium.

Healthy units, such as Denizbank in Turkey, will be sold.

A 'bad bank' supported by state guarantees will hold 95 billion euros in bonds, including 12 billion euros of sovereign debt of weaker euro zone periphery nations.

Including 7 billion euros of securities linked to U.S. mortgages, France and Belgium may need to provide guarantees to cover up to 200 billion euros of assets, which would be more than 55 percent of Belgian GDP.

The key issues for Sunday's talks will be how to divide up the 'bad bank' assets, how much Belgium should pay to nationalize Dexia's Belgian banking business and whether others, such as Belgium's regions, would be involved in its purchase.

Dexia's shares have been suspended since Thursday afternoon and have lost 42 percent since last Friday. ($1 = 0.741 Euros)

(Writing by Marie Maitre; Editing by Hans-Juergen Peters)