Germany, the only major euro zone member to retain a top-notch credit rating, refused on Monday to consider boosting the bloc's rescue fund, while Greece was under pressure to urgently break a deadlock in debt swap talks if it is to avoid an unruly default.
European leaders vowed to press ahead with a fiscal pact for stricter budget discipline and hasten the launch of a permanent bailout fund for the 17-nation euro area, the European Stability Mechanism, in the light of Standard & Poor's move last Friday.
The downgrading of France, Austria, Italy and Spain in particular means the European Financial Stability Facility risks losing its AAA rating or having less money to lend, unless remaining triple-A nations raise their guarantees, euro zone officials said.
But German Chancellor Angela Merkel's spokesman, Steffen Seibert told reporters: The government has no reason to believe that the volume of guarantees that the EFSF has now should not be sufficient to fulfill its current obligations.
We should not forget that it has been decided to significantly move forward the ESM and to have it in place in mid-2012, one year earlier than planned.
Financial markets took the downgrades in their stride, with the euro and government bond yields broadly steady. Traders said the European Central Bank bought Italian and Spanish bonds to offset pressure from S&P's salvo.
But the relief could be shortlived due to the rising risk of a disorderly Greek default unless Athens can secure a last-ditch agreement with its private creditors to accept voluntary losses on their holdings of Greek bonds.
A growing number of experts, including a Standard & Poor's official, are warning a default is on the cards, after Greece's talks with creditors broke down on Friday.
European shares rebounded to end higher despite fears that banks would suffer knock-on downgrades in the wake of the governments whose debt they hold.
Yields on French treasury bills eased slightly in the first test of investor appetite for the country's debt since it was stripped of its coveted triple-A rating.
The head of Austria's debt office told Reuters the loss of Vienna's AAA status had also been priced into the market already, and Austria was able to sell treasury bills on Monday at rates very close to zero.
French President Nicolas Sarkozy brushed off the historic loss of Paris' top credit rating for the first time since 1975, a blow to his campaign for re-election in May, saying France's policy would not be dictated by rating agencies.
Contrasting S&P's move with a statement by rival watchdog Moody's, which still has France on an Aaa rating, he said: My deep belief is that it changes nothing. We must reduce the deficit, we must reduce our spending and we must improve the competitiveness of our economy to return to a path of growth.
LOSERS TO PAY?
Italian Prime Minister Mario Monti, whose debt-laden country was downgraded by two notches along with Spain, called last week during a visit to Berlin for the EFSF to be increased to ward off attacks on his country's bonds.
But a senior politician in Merkel's conservative CDU party, Michael Meister, said it was the downgraded countries that should increase their guarantees for the fund.
Germany was not downgraded so our contribution should not be changed. Countries that were affected must contribute more to the guarantees, Meister told Reuters.
Barely a month after an injection of bailout funds helped to avert bankruptcy, Greece is back at the centre of the euro zone crisis as fears of a default and a possible euro zone exit.
Cash-strapped Athens needs a deal with the private sector within days to avoid going bankrupt when 14.5 billion euros of bond redemptions fall due in late March. Without a private sector bond swap involving a voluntary writedown, a 130 billion euro second international bailout for Greece could fall apart.
Talks with creditor banks broke down last Friday because of different views on what interest rate is acceptable, the head of the group leading private sector talks said.
They are looking at the private sector to accept interest rates that they would not accept (themselves), which is completely unreasonable, said Charles Dallara, managing director of the Institute of International Financial.
He said the banks were very surprised at the stance taken by some officials representing both governments and multilateral institutions, without naming them.
Sources familiar with the talks said EU paymaster Germany was pressing for new bonds to be given to banks in the planned swap to carry a low coupon of less than four percent that would increase the banks' effective losses to 75 percent.
The International Monetary Fund was also weighing on the talks by warning that the Greek economy and the euro zone's economic outlook have worsened since the bailout package was agreed in October, raising Athens' funding needs to make its debt sustainable by 2020, they said.
Greece put a brave face on the standoff.
There is a little pause in these discussions, Greek Prime Minister Lucas Papademos told CNBC television.
But I am confident that they will continue and we will reach an agreement that is mutually acceptable in time.
(Additional reporting by Lefteris Papadimos in Athens, Steve Slater and Richard Hubbard in London, Jan Strupczewski in Brussels and Fiona Ortiz in Madrid; Writing by Paul Taylor; Editing by Susan Fenton)