Moody's cut Spain's debt rating on Thursday, pushing the euro lower and deepening the sense of crisis in the 17-nation currency bloc on the eve of a crucial summit.
German Chancellor Angela Merkel signaled to lawmakers in a closed-door meeting that she was prepared to agree an increase in Europe's rescue fund later this month, participants said, but only under conditions that other states may find difficult to accept.
Investors pushed the single currency to a one-week low under $1.38, the risk premium on Spanish bonds widened and the cost of insuring Spanish, Greek and Portuguese debt against default rose as a fresh wave of euro zone jitters hit financial markets.
Leaders from the currency area are expected to back a watered-down version of a German-French plan to boost economic competitiveness at Friday's Brussels summit but are unlikely to overcome sharp differences over whether the rescue fund should be given new powers that would help it ease the burden on highly-indebted euro states.
A German official lowered any expectation of a breakthrough, saying no decisions would be taken on strengthening the European Financial Stability Facility (EFSF) on Friday.
The question of raising the fund's lending capacity would be decided in a package at the end of March, he said, and Berlin opposed giving the EFSF or its successor any direct or indirect role in buying troubled states' bonds on the secondary market.
Merkel told members of the Bundestag's European affairs committee, according to the participants, that boosting the fund would depend on countries that do not have a triple-A rating injecting capital, a step some of them have already signaled they will resist.
EU diplomats said France and several other countries want at least an outline agreement on Friday on the remit of a planned permanent financial rescue mechanism for the euro zone.
"The quicker we get a deal the quicker we calm the markets," one senior diplomat said.
Traders said the euro could fall further due to market concerns that Friday's 17-nation meeting and a summit of the full 27-nation European Union on March 24-25 may fail to agree on decisive action to tackle the debt crisis.
"If officials make no progress and Germans remain unwavering in their demands, the likelihood of a capitulation (in the euro) will be significantly higher," said Jessica Hoversen, currency strategist at MF Global in Chicago.
SPAIN, PORTUGAL UNDER PRESSURE
Moody's Investors Service cut Spain's sovereign debt rating one notch to Aa2 and warned of further downgrades, estimating the capital shortfall at the country's banks at 40-50 billion euros, or as much as 110-120 billion euros under a more severe stress scenario.
That clashed starkly with a new 15 billion euro shortfall estimate from the Bank of Spain, which raised questions about the credibility of official forecasts.
"(Moody's) believes there is a meaningful risk that the eventual cost of the recapitalization effort could considerably exceed the government's current projections," the credit ratings agency said in statement.
Bond market pressure on Portugal to become the third euro zone state to seek an EU/IMF rescue after Greece and Ireland has risen this week with 10-year bond yields at euro lifetime highs above 7.5 percent, a level Lisbon says is unsustainable.
A French presidential source said euro zone leaders would discuss Portugal's measures to cope with its financial problems at Friday's summit but they were not working on a rescue plan.
EU sources said Portuguese Prime Minister Jose Socrates is under intense pressure from his peers and the European Central Bank to announce additional austerity measures and accelerate economic reforms. The sources said he would make a statement to the leaders at the start of a summit on Friday on his commitment to deeper reforms, including to the labor market.
Socrates reiterated in parliament on Thursday that Portugal could solve its financial problems without outside help.
The ECB said debt-strained euro zone governments have yet to demonstrate convincingly the strength of their deficit-cutting efforts and may be weakening their commitments.
"Overall, current (consolidation) policies and plans give rise to concern for a number of reasons," the ECB said in its monthly bulletin, without singling out individual countries.
After supporting Portuguese government bonds several times this year, the ECB appears to have refrained from intervening in recent days, traders say, in a pattern reminiscent of the run-up to Ireland's bailout request last November.
GREECE, IRELAND WORRIES
Financial markets are also concerned about the growing risk that Greece and Ireland may have to restructure their debts despite EU/IMF bailouts which have only bought time.
Moody's slashed Greece's credit rating by three notches on Monday, citing an increased risk of default or restructuring, possibly before 2013.
Greek 10-year bond yields rose to a post-crisis high above 12.8 percent and two-year yields have risen sharply.
"There appears to be a growing risk that Greece could struggle to meet its financing needs before too long," Capital Economics said in a research note. "We think that the markets' increasingly gloomy stance is justified."
Greek Prime Minister George Papandreou told French daily Le Monde that lowering interest rates and extending the maturity of rescue loans "would be decisive factors to guarantee that we continue to meet our long-term objectives."
Merkel said Greece should be given longer to repay euro zone loans, telling Bild newspaper that insisting Athens solve its fiscal problems in three years would only cause fresh turbulence.
Sources said she had told the parliamentary committee that steps to ease the burden of both Greece and Ireland would be conditioned on new pledges by those countries, citing movement from Athens on privatizations and compromises from Dublin on corporate tax base issues.
Germany and its northern allies remain reluctant, however, to accept a significant reduction in the punitive interest rates charged to Athens and Dublin, which compound their debt woes.
Spain has escaped the bond market firing line this year by announcing budget cuts, a bold pension reform, privatization measures and a plan to recapitalize the regional public savings banks hard hit by the collapse of a real estate bubble.
But the prospect of higher interest rates, raising mortgage costs to stretched Spanish households and increasing the risk of more loans to property developers turning sour, has raised market estimates of the cost of restructuring the banks.
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