By William James
LONDON (Reuters) - A deal to boost the euro zone's rescue fund, no matter when it comes, will not save Portugal from financial market pressure to seek a bailout and might only buy time for Spain as it tries to avoid becoming the next target.
The European Council meets on Thursday and Friday and had been expected to sign off on a "comprehensive solution" to the crisis that has crippled the fundraising capability of euro zone countries running high deficits and financing large debt piles.
Draft conclusions prepared for the summit showed on Wednesday that the leaders had put off until June giving final approval to how to implement the measures.
However, analysts said the measures on the table, having been agreed in principle earlier this month, contain little to stem the tide of bond market pressure threatening to sweep Portugal into a bailout, and could turn market focus on Spain.
"There is no silver bullet coming out of Brussels... there's nothing in what has been agreed over the last few weeks which really changes the picture for Portugal," said Deutsche Bank economist Gilles Moec.
Adding to pressure on Lisbon, a vote scheduled for late Wednesday on fresh austerity measures aimed at reassuring markets threatens to topple Portugal's minority government.
The key points of the bailout fund reforms are a commitment to increase the effective lending capacity of the facility to 440 billion euros and, under special circumstances, to allow the fund to buy government bonds at auction.
Neither addresses the eye-watering cost of funding Portugal's debt burden. For this reason, many have already written off its chances of avoiding a bailout.
Portugal's cost of funding exceeds 8 percent on five-year debt, with borrowing for more than three years costing more than 7 percent -- a level widely seen by the market as unsustainable in the long term.
This view was reflected in the spread between two- and 10-year yields, which was last at 101 basis points. The yield gap has narrowed by around 75 bps during March as the market has gradually priced in a greater short-term risk of a debt restructuring.
"As we saw with Greece and Ireland, the curve viciously flattens as a credit event approaches. Concerns over Portugal's ability to fund itself sustainably are seeing history repeat itself," said Rabobank strategist Richard McGuire.
The cost of insuring against a Portuguese default also showed investors saw greater short-term risks, with the price of three-year credit default swaps exceeding that of the normally more expensive 5-year CDS.
A bailout for Portugal could bring Spain into the crosshairs of those looking for the next weak link in the euro zone, but not before the bloc's fourth largest economy finds some short-term respite.
Spain has so far managed to distance itself from Portugal's woes. Its two-year bondshave outperformed those of Italy by 100 basis points since late December in a positive market reaction to progress on shoring up its banking sector.
The steps to ensure the European Financial Stability Facility (EFSF) can lend to its full 440 billion euro capacity, omce signed, should ease the worries of those who feared Spain was too big to be bailed out under the original agreement.
"Spain has the benefit of the doubt for now, it has done quite a bit of fiscal work and the market is relatively confident that the funding for the cajas will not be more than 15 billion (euros)," Lloyds Bank economist Kenneth Broux said.
The Bank of Spain said earlier this month that it would cost 15 billion euros to shore up ailing cajas, or savings banks.
However, Royal Bank of Scotland strategists recommended using any tightening of the Spanish yield spread over Bunds to position for a longer-term widening.
Plans to allow the EFSF to buy bonds at auction were seen as a way of easing bailed-out sovereigns back into debt markets rather than a means of pre-emptively relieving funding strains.
This represented a missed opportunity to build a structure that could halt the spread of the crisis by allowing the fund to buy up debt in secondary markets without requiring a country to have already accepted a bailout program, analysts said.
As a result, investor morale is likely to remain sensitive to slips in estimates on recapitalizing Spanish savings banks after a spiral in Irish banks' bailout costs forced Dublin to ask for aid and left many investors out of pocket.
"The market probably will toy around with the idea that (Spain) will be OK for a while but the crisis has taught us that complacency can be easily punished," Sian said.
(Graphic by Kirsten Donovan)