The European Central Bank faced a decision on Sunday whether to buy Italian bonds to try to prevent the euro zone debt crisis from widening, while global policymakers conferred on the twin financial crises in Europe and the United States.
After a week that saw $2.5 trillion wiped off world stock markets, political leaders are under searing pressure to reassure investors that Western governments have both the will and ability to reduce their huge and growing public debt loads.
ECB President Jean-Claude Trichet wants the policy-setting Governing Council to take a final decision on buying Italian paper after Prime Minister Silvio Berlusconi announced new measures on Friday to speed up deficit reduction and hasten economic reforms, one ECB source said.
The source said that if the ECB council opted to intervene on Italy at a crucial conference call expected to have started at 1700 GMT (1200 EDT), the ECB and national central banks would start buying Italian bonds when markets open on Monday.
That would likely prompt a sizable relief rally on global markets. If it does not act, the reverse would be true.
Another source said the council would look too at possible emergency liquidity measures to prevent money markets freezing. The fourth anniversary of the global credit crunch which ushered in the financial crisis looms this week.
The back-and-forth between Standard & Poor's and the Obama administration over whether the downgrade of Washington's AAA rating to AA+ was justified continued on U.S. Sunday-morning talk shows where a senior official from the ratings agency said its concerns about political impasse in Washington were valid.
John Chambers, an S&P managing director, said on ABC's This Week that years may be needed to regain AAA status and even them it would take, I think, more ability to reach consensus in Washington than what we're observing now.
White House economic adviser Gene Sperling blasted the S&P ruling on Saturday night, saying it smacked of an institution starting with a conclusion and shaping any arguments to fit it.
The U.S. Treasury said S&P's debt calculations were off by $2 trillion but the agency said that didn't change the fact that the U.S.'s longer-term debt prospects were worsening.
Twin debt crises in the United States and Europe had policy makers scrambling to keep financial markets from panic.
The ECB reactivated its sovereign bond-buying programme last Thursday but purchased only small quantities of Irish and Portuguese bonds, seeking tougher austerity measures from Italy. That did nothing to stem market attacks on Italian assets.
Berlusconi's plans entail moving up a balancing of the budget by one year to 2013, enshrining a balanced budget rule in the constitution and pushing through welfare and labor market reforms after talks with trade unions and employers.
He gave little detail about how that would be achieved and the measures will take some time to enact.
Markets in the Gulf region and in Israel, among the first to trade since the U.S. credit downgrading, tumbled on Sunday on worries the U.S. ratings downgrade and European debt woes may trigger another global downturn.
G-20, G-7 CRISIS CONTACTS
South Korea said finance deputies from the Group of 20 big economies addressed the European crisis and U.S. sovereign rating downgrade in an emergency conference call on Sunday morning Asian time.
A Japanese government source said finance leaders from the Group of Seven big developed economies would also discuss the crisis and might issue a statement afterwards. The timing of a planned conference call, expected on Sunday, was unclear but was likely before Asian markets reopen on Monday.
French President Nicolas Sarkozy, who chairs the G7 and G20 forums this year, conferred with Britain's Prime Minister David Cameron on Saturday.
Both agreed the importance of working together, monitoring the situation closely and keeping in contact over the coming days, a spokesman for Cameron said.
Over time, S&P's move could ripple through markets by pushing up borrowing costs and making it more difficult to secure a lasting recovery.
S&P chief David Beers told Fox News Sunday that the Treasury Department's criticism of the credit rating agency's analysis was a complete misrepresentation. Even with the debt limit agreement passed by the U.S. Congress, he said, the underlying debt burden of the U.S. is rising and will continue to rise over the next decade.
Asked about prospects for a further lowering of the U.S. rating, Beers said the agency's negative outlook meant that risks are on the downside.
ALARM IN GERMAN, FRENCH MEDIA
Newspapers in Germany, the euro zone's reluctant bankroller, were both incredulous and gloomy on Sunday about the financial upheaval.
Welt am Sonntag dedicated an entire section to global economic uncertainties, entitled Der Crash and wrote: No one could have foreseen this dramatic crash and now the situation can only be endured with gallows humor.
French newspapers carried grim headlines with Le Journal du Dimanche trumpeting The world on the edge of collapse with a sub-headline saying: The week starting should be crucial. Markets from now on are living in fear of a crash.
Washington's Asian allies rallied round the battered superpower, with Japan and South Korea both saying their trust in U.S. Treasuries remained unshaken and urging investors not to panic.
I expressed our country's position on the (G20 conference) call that there will be no sudden change in our reserve management policy, South Korean Deputy Finance Minister Choi Jong-ku told Reuters by telephone, referring to Seoul's heavy ownership of U.S. bonds.
There's no alternative that provides such stability and liquidity, added Choi.
The most immediate concern for financial markets was the debt crunch in the euro zone, where yields on Italian and Spanish debt have leaped to 14-year highs on political wrangling and doubts over the vigor of budget cuts.
The ECB has got to confront the speculators who are out to test the policymakers, said Mike Lenhoff, chief strategist at Brewin Dolphin in London. (The U.S. downgrade) might cause some upheaval temporarily. The big issue is the euro zone and its implications for the banking system.
SPLITS IN ECB
The ECB remains divided over whether to buy bonds at all, with four German, Dutch and Luxembourg members of the 23-member council opposed, ECB sources said. Even some of those in favor say Italy should do more to front-load its reforms.
The danger is that further pressure on Italian and Spanish bonds could further undermine a damaged European banking system and lock Italy, the world's No. 8 economy, out of the market.
Indeed, doubts are growing in the German government that Italy could be rescued by the European emergency fund, even if the fund were tripled in size, according to Der Spiegel.
Italy's financial needs are so huge that it would overwhelm resources, according to government experts, Der Spiegel said in its online edition. Italy's public debt is about 1.8 trillion euros, or 120 percent of its national output.
Germany has consistently said troubled euro-zone governments should focus on spending cuts and internal reforms, not bailouts. The European Financial Stability Fund currently has 440 billion euros and would need to be expanded to cater for the likes of Italy and Spain.
China, the largest foreign holder of U.S. debt, took the world's economic superpower to task for allowing its fiscal house to get into such disarray.
On Sunday, a commentary in the People's Daily, the main newspaper of the ruling Communist Party, said Asian exporters, who depend on demand from the United States, could be among the biggest victims of the mounting U.S. economic woes.
The lowering of the United States' long-term sovereign credit rating has sounded a warning bell for the international currency system dominated by the U.S. dollar, said economist Sun Lijian, writing in the paper.
(Additional reporting by Laura McInnis in Washington, Tova Cohen in Tel Aviv, Sarah Marsh in Berlin, Astrid Wendlandt in Paris, Kim Yeonhee and Yoo Choonsik in Seoul, Praveen Menon and Shaheen Pasha in Dubai, and Reuters bureaux worldwide; Writing by Mark Heinrich and Glenn Somerville; Editing by Jackie Frank)