Euro zone leaders agreed in principle on Friday to write limits on public debt and budget deficits into national law, meeting a German condition for a stronger euro zone financial safety net.
They also moved closer to agreeing a comprehensive package of measures that they hope will draw a line under the year-long debt crisis, euro zone sources said, although it was not clear a deal would be completed on Friday.
The deficit agreement, which will be formally approved at a summit in two weeks, once other elements of the euro zone's response to the debt crisis are in place, also envisages higher retirement ages, wage growth in line with productivity gains and bank resolution schemes.
Agreement in principle on the Pact for the Euro, but still discussing the other elements of the package, Herman Van Rompuy, the president of the European Council and host of the meeting, said in a posting on his Twitter page.
Germany, which has limits on debt written into its constitution, wants other euro zone members to agree to some national limits to avoid a repeat of the sovereign debt crisis, sparked by years of unchecked overspending in Greece.
Euro area member states commit to translating EU fiscal rules as set out in the Stability and Growth Pact into national legislation, a draft of the agreement, obtained by Reuters before the meeting, said.
The Stability and Growth Pact, budget rules that underpin the euro currency shared by 17 countries, sets a limit of 3 percent of gross domestic product on budget deficits and 60 percent of GDP on public debt.
Each country will choose its own way of introducing the limits into national law but it will have to make sure that it has a sufficiently strong binding and durable nature (e.g. constitution or framework law), the draft agreement said.
The deal brings the euro zone a step closer to boosting the effective lending capacity of the euro zone rescue fund, the European Financial Stability Facility, as called for by the European Commission and several member states.
Markets see more effective firepower for the 440 billion euro EFSF and an option to buy bonds of distressed governments as an important way to restore confidence in euro zone sovereign debt, at a time when many investors believe Portugal will have to follow Greece and Ireland in asking for a bailout.
The EFSF has an effective lending capacity of only 250 billion euros ($345 billion) because of guarantees needed to retain its triple-A credit rating. To increase the capacity, euro zone states would have to increase their guarantees.
Merkel told lawmakers in her party on Thursday that Germany would only increase its guarantees if non-triple A states put in more capital, according to participants at the closed-door meeting, something several of those states have opposed.
Germany, Finland and the Netherlands, where public opinion opposes aid for what are seen as profligate peripheral states, have opposed changes to the EFSF, arguing there was still enough money in it to help Lisbon if needed and it was up to Portugal to convince markets its finances were sustainable.
In response, Portugal announced new spending cuts on Friday,
putting the onus back on Germany to agree to a stronger EFSF as investors doubt that Portuguese efforts alone will suffice.
Yields on the country's benchmark 10-year bonds jumped to 7.87 percent on Friday despite the new measures, from 7.69 on Thursday, and the euro fell to a one-month low of $1.3750 from $1.3792.
To calm markets down, you need to see something coming from the European Union -- some improvement relating to the EFSF or the new stability mechanism. You need a two-way answer, said Cristina Casalinho, Chief Economist at Banco BPI.
A German government source said there were positive signals that Greece and Ireland might also announce new moves at the summit, opening the way for Germany to offer them more help.
Chancellor Angela Merkel was upbeat about Portugal's extra austerity steps, saying they could lead to a positive outcome.
Euro zone leaders would like to dispel market concerns about the ability of Greece and, to a lesser extent Ireland, to return to sustainable public finances without a debt restructuring.
A German source said Merkel could accept some easing of the terms on the Greek and Irish bailout loans if Athens speeded up promised privatizations and Dublin was more forthcoming on the proposal for a common corporate tax base in the euro zone.
But new Irish Prime Minister Enda Kenny said Dublin, which has an ultra-low 12.5 percent corporate tax rate, would resist German efforts to introduce a common corporate tax base. This would be a harmonization of tax by the back door, he said.
Greece said weaker-than-expected revenues and higher spending had widened its state budget shortfall in the first two months of 2011, blowing it off course to meet the tough fiscal targets set out by the EU and the IMF.
Moody's slashed Athens' credit rating by three notches on Monday citing a heightened risk of default.
A senior EU source said euro zone leaders would issue a statement on Ireland, Portugal and Greece on Friday.
They would welcome Portugal's latest steps to reduce its budget deficit and call on Greece to work harder to implement its EU/IMF economic adjustment program, amid signs that Greece is not going to meet its targets.
EU diplomats said other euro zone states would not formally sign up to the competitiveness pact until they secured a German commitment to strengthen the rescue fund.
The head of global sovereign ratings at Fitch said failure by the euro zone to agree a clear and coherent strategy on the debt crisis would intensify the risk of credit downgrades.
(additional reporting by Andreas Rinke, Luke Baker, James Mackenzie and Carmel Crimmins; Writing by Noah Barkin and Jan Strupczewski, editing by Tim Pearce)