By Jan Strupczewski and Luke Baker
BRUSSELS (Reuters) - Euro zone leaders are set to agree a "competitiveness pact" at a summit on Friday and will push Portugal to announce new reforms to increase market confidence as they seek to draw a line under the regions' debt crisis.
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Germany has lowered expectations for a major breakthrough at the summit, saying the best that can be hoped for is an agreement on competitiveness.
Bigger decisions to tackle the crisis -- such as whether to strengthen the euro zone bailout fund -- will be handled at a summit later this month.
China offered its support to the region after ratings downgrades this week of Greece and Spain underlined fears of possible sovereign debt defaults.
"China has confidence in the euro zone," China's central bank governor, Zhou Xiaochuan, told a news conference in Beijing. "Although some euro zone nations have hardships, we will vigorously support them in surmounting their present fiscal difficulties and improving their economies."
Germany's aim on Friday is to get the 17 euro zone states to enshrine EU rules on deficits and debt in national law -- effectively making it illegal for any euro zone member to exceed fixed deficit and debt limits in the future.
The EU's Stability and Growth Pact sets a government deficit limit of 3 percent of GDP and debt of 60 percent of GDP. Translating that into national laws would entail the adoption of a "debt brake," similar to what German law requires.
"Euro area member states commit to translating EU fiscal rules as set out in the Stability and Growth Pact into national legislation," the latest draft of the agreement reads. Euro zone leaders are expected to sign up to it on Friday.
"Member states will retain the choice of the specific national legal vehicle to be used, but will make sure that it has a sufficiently strong binding and durable nature (e.g. constitution or framework law)," the draft said.
If Germany and France can get the remaining euro zone members to sign up to the competitiveness pact -- which also includes moves to gradually raise retirement ages and work toward a common corporate tax base -- there is an expectation that Germany will agree to back a stronger bailout fund.
The European Financial Stability Facility, used to bail out Ireland, has an effective lending capacity of 250 billion euros ($345 billion), not its full 440 billion, because of guarantees needed to retain its triple-A credit rating.
Increasing the capacity will require German backing and all member states to increase their contributions or guarantees, not a straightforward task given popular opposition to bail outs. That debate will be taken up on March 24, but its outcome may depend on how much backing Germany gets on Friday.
While Euro zone leaders will hail any agreement on competitiveness as a big step in tackling the debt crisis, analysts regard it as a sideline issue, saying it goes nowhere toward tackling the fundamental problem of bad banking debts and highly indebted sovereigns with poor growth prospects.
In that respect, Friday's summit merely clears the ground for a meeting on March 24-25, when a "comprehensive package" of measures leaders hope will draw a line under the crisis will be debated.
PORTUGAL BACK UNDER PRESSURE
Measures in the comprehensive package include the EFSF plus the European Stability Mechanism, a permanent fund that will replace the EFSF from mid-2013, and more stress tests to examine the stability of Europe's major banking firms.
While Germany has hinted that a deal on Friday may ease the way for it to back a stronger and potentially more flexible EFSF at the end-March summit, there are no guarantees.
German Chancellor Angela Merkel's political allies are opposed to bolstering the EFSF, which would require more taxpayer-backed guarantees, and do not want the fund to be used to buy distressed euro zone debt, as many other countries want.
Merkel's coalition lost an important regional election in Hamburg last week and is expected to lose another in Baden-Wuerttemberg on March 27, piling pressure on the chancellor to stick closely to what voters want, which is no more German taxpayer funds being used for EU bailouts.
A month ago, an enlargement of the effective lending capacity of the EFSF looked likely, as did the possibility of the fund being used to buy distressed euro zone bonds on the secondary market, or to lend money to countries such as Greece and Ireland to buy back bonds. Now the outlook is less certain.
A senior euro zone source expressed confidence that despite Germany's reluctance there would be a deal on March 24-25.
"I actually have no doubt that in the end we will come up with a fairly solid package on all of this," the source said.
Euro zone sources said Portugal, which markets see as the next candidate for a bailout program from the EU and the International Monetary Fund, was under euro zone pressure to announce new reforms to boost market confidence in its finances.
"The message that they will be facing tomorrow is that they need to do more," the first euro zone source said, noting that a rise in Portuguese 10-year bond yields to 7.69 percent on Thursday made it clear the market was not convinced the current measures to stabilize public finances were enough.
For months Portugal has said that it does not need EU/IMF assistance and can continue to fund itself in the market. But if there is no breakthrough on March 24/25, the likelihood of Portugal needing a bailout will increase. Already the majority of EU states believe it will happen in April.
"The Portuguese authorities are fully aware of what they need to do and we are talking to them to help them understand the degree of urgency," the second euro zone source said.
(Reporting by Jan Strupczewski; Editing by Michael Roddy & Kim Coghill)