Euro zone debt crisis intensifies on summit eve

By Elizabeth O'Leary and Julien Toyer

MADRID/BRUSSELS (Reuters) - The euro zone's debt crisis intensified on the eve of a summit of the currency bloc when Moody's downgraded Spain's credit rating on Thursday and bond markets heaped pressure on Portugal to seek a bailout.

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 seem unlikely to resolve sharp differences over the size and scope of the euro zone's rescue fund.

A German official said the question of raising the fund's lending capacity would not be decided on Friday but in a package at the end of March, and Berlin opposed giving it any direct or indirect role in buying troubled states' bonds.

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 recapitalization effort could considerably exceed the government's current projections," the credit ratings agency said in statement.

The Spanish Finance Ministry voiced surprise that Moody's had acted without waiting for a Bank of Spain report on the restructuring costs due out later on Thursday.

The euro fell about half a cent to a one-week low of $1.3804 on the downgrade. The risk premium on Spanish bonds widened and the cost of insuring Spanish, Greek and Portuguese debt against default rose.

Traders said the single currency could fall further due to market concerns that Friday's euro zone 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.

PORTUGAL UNDER PRESSURE

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 diplomats 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.

EU sources said he would make a statement to the leaders at the start of a summit on Friday discussing his commitment to deeper economic reforms, including to the labor market.

The ECB said on Thursday that debt-strained euro zone governments have yet to demonstrate convincingly the seriousness 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.

Socrates told his Socialist party this week that calling in the International Monetary Fund would be a humiliation.

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 of 12.8 percent on Wednesday 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 on Thursday. "We think that the markets' increasingly gloomy stance is justified."

Greek Prime Minister George Papandreou told French daily Le Monde on Thursday 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."

Slovak Prime Minister Iveta Radicova broke a euro zone taboo on Wednesday by acknowledging publicly the risk that Greece may default and that Portugal may need a bailout.

In a Reuters interview, she advocated easing the terms on euro zone emergency loans to Athens and Dublin as a way to ease the burden of debt service.

But Germany and its northern allies are reluctant to accept any significant reduction in the interest rate.

Spain has escaped the bond market firing line this year by announcing budget cuts, a bold pension reform, privatisation 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.

Moody's said the overall cost was likely to be nearer 40-50 billion euros. In a more stressed scenario, recapitalization needs could even rise to around 110-120 billion euros, it said.

(Additional reporting by Noah Barkin and Stephen Brown in Berlin, Marc Jones in Frankfurt, Martin Santa in Bratislava, Luke Baker in Brussels; writing by Paul Taylor, editing by Mike Peacock)