Greek borrowing costs soared to new highs on Thursday and pressure rose on other financially weak euro zone countries after Germany suggested for the first time that Athens may have to restructure its debt.
European policymakers scrambled to reassure investors that a restructuring for Greece was not on the agenda, saying such a step could have dire consequences for European banks and the fragile economy of the 17-nation euro zone.
The Greek government also ruled out a restructuring, promising to deliver on the ambitious fiscal goals set out for it by the EU and International Monetary Fund last year in exchange for a 110 billion euro ($160 billion) rescue.
But doubts have risen in recent weeks about whether Greece can achieve those targets and restore confidence in its finances in time to return to the capital markets for funding next year.
With a debt mountain that is expected to approach 160 percent of annual output by 2013 and EU/IMF money due to run out that same year, some move to reduce Greece's debt burden such as reducing or postponing repayments to its bond investors looks increasingly unavoidable.
A Reuters poll on Thursday showed analysts believe there is a 60 percent chance Greece will have to restructure its debt in the coming years. They put the chances for Ireland at 40 percent and Portugal at 30 percent.
German Finance Minister Wolfgang Schaeuble became the first senior euro zone official to acknowledge publicly that restructuring may be a possibility in an interview in the Thursday edition of German newspaper Die Welt.
Schaeuble said additional measures to deal with Greek debt would be needed if a report due in June showed it was unsustainable. He said any restructuring would have to be done on a voluntary basis before 2013, when new EU rules take effect that could compel private investors to shoulder losses.
German officials later tried to play down the comments, which contributed to a surge in Greek bond yields. Two-year debt rose above 18.4 percent, 10-year bonds hit 13.4 percent and the cost of insuring 5-year Greek debt against default pushed up to a record high of 1,070 basis points.
Spanish bond yields, which have remained steady since neighbor Portugal announced last week it would follow Greece and Ireland in seeking a bailout, also edged higher.
On Friday, Greece will present new austerity and privatization plans in an attempt to convince markets it can tidy up its finances and avoid a restructuring.
Although its debt levels look unsustainable, opposition to what would be the first debt restructuring in western Europe in six decades is high, particularly at the European Central Bank.
The ECB holds an estimated 40-50 billion euros of Greek debt itself and worries such a move would hammer euro zone banks and set off a new round of contagion. Greek, German and French banks have the biggest exposure to Greek sovereign debt.
According to our analysis, a debt restructuring would result in the failure of a large part of Greece's banking system, ECB Executive Board member Lorenzo Bini Smaghi told Italian business daily Il Sole 24 Ore.
The Greek economy would be on its knees, with devastating effects on social cohesion and the maintenance of democracy in that country, he said.
European Economic and Monetary Affairs Commissioner Olli Rehn, in Washington for meetings of the IMF and World Bank, said debt restructuring was not an option. Nobody should underestimate the risk of a contagion effect on other sovereigns, he said.
IMF first deputy managing director John Lipsky also played down the need for restructuring, but acknowledged in a Reuters Insider interview that adjustments and mid-course corrections in Greece's bailout program may be required.
Greece epitomizes the troubles facing Europe's most-indebted economies as they struggle with budget cuts which undermine their ability to grow and service their debt.
The severe economic recession and the lack of improvement in tax revenues suggest Greece may already be in the vicious spiral of too tight fiscal policy and too weak economic performance, where a write-off of part of the debt would be the only possible way out, said Giada Giani, an economist at Citibank, in a report.
European officials are hoping that an 80 billion euro bailout for Portugal, expected to be sealed by mid-May, will be the last one and debt markets have broadly shown that Spain and Italy are succeeding in keeping investors' faith.
The Bank of Spain approved the capital raising plans of 13 banks on Thursday, saying nine of them may need state funds to bring their capital ratios up to tough new minimum levels.
Spain's unlisted savings banks, known as cajas, are undergoing a massive state-driven restructuring to reassure markets about the stability of the Spanish banking system.
In neighboring Portugal, the leader of the largest labor union told Reuters he was considering calling a general strike to step up protests against austerity measures that are expected to deepen under the looming EU/IMF bailout.
European Commission and IMF officials started poring over Portugal's public accounts this week, and market nervousness could rise ahead of the weekend when a Finnish parliamentary election looks set to boost the influence of eurosceptic parties opposed to a bailout for Lisbon.
In contrast to the struggling economies on Europe's southern periphery, bloc heavyweight Germany raised its GDP forecasts on Thursday, predicting growth of 2.6 percent this year versus 2.3 percent previously.
Senior ECB policymakers also stepped up warnings about rising inflation, in a sign the central bank could embark on a steady run of interest rate rises after tightening monetary policy last week for the first time in nearly three years.
(Additional reporting by Madrid, Lisbon, Berlin and Washington bureaus; writing by Noah Barkin; editing by David Stamp)