Germany refused to be rushed into boosting the euro zone's rescue fund after Moody's cut Spain's credit rating on Thursday and markets piled pressure on Portugal on the eve of a summit of the currency bloc.
The euro fell to a one-week low of $1.3804, 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 of the 17-nation 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 the size and scope of the rescue fund.
A German official lowered any expectation of a breakthrough, saying no decisions would be taken on strengthening the European Financial Stability Facility on Friday.
"The German government does not believe it is the right time to discuss this," he told a pre-summit briefing.
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.
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 that restructuring savings banks will cost more than double the government's 20-billion-euro forecast.
"(Moody's) believes there is a meaningful risk that the eventual cost of the recapitalisation effort could considerably exceed the government's current projections," the credit ratings agency said in statement.
It said the overall cost was likely to be nearer 40-50 billion euros and in a more stressed scenario, recapitalisation needs could even rise to around 110-120 billion euros.
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 labour market.
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".
German Chancellor Angela 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. She said she ruled out a restructuring of Greek debt.
However, Germany and its northern allies are reluctant to accept any 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, privatisation measures and a plan to recapitalise 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.
