A political crisis in Portugal that has forced the resignation of its prime minister dominated the start of a summit of EU leaders on Thursday, with Lisbon rejecting intense pressure to seek a bailout package.
Prime Minister Jose Socrates quit on Wednesday after parliament rejected new austerity measures that his government unveiled to avoid being forced to seek EU/IMF financial assistance, as euro members Greece and Ireland did last year.
Despite stepping down, Socrates came to the two-day summit. He remains adamantly opposed to requesting aid and has made it clear he intends to hold that line, at least until a new Portuguese government is formed, probably after early elections in about two months' time.
The government will continue to fight against the possibility of resorting to foreign aid, cabinet minister Pedro Silva Pereira said in Lisbon. The main opposition leader, Pedro Passos Coelho, who hopes to oust Socrates' Socialists, said in Brussels he hoped that Portugal would avoid a bailout.
The fall of the government left Portugal in limbo and underscored political obstacles the single currency bloc faces in solving a debt crisis that has deepened over the past year.
This is bad news, Dutch Prime Minister Mark Rutte said of Portugal. If you want a bailout, then you first need to show that you are solving your problems, that you are bringing your debt under control, that your public finances are in order.
Only a few days ago, the two-day summit had been expected to deliver a comprehensive package of new measures that would reassure financial markets, but now leaders have been thrown onto the defensive and could struggle to show unity and resolve.
German Chancellor Angela Merkel, the euro zone's reluctant paymaster, said whoever formed the next Portuguese government would have to stick to the deficit reduction commitments agreed by the outgoing administration.
Senior euro zone officials said Portugal was likely to need 60-80 billion euros in assistance from the EU rescue fund and the International Monetary Fund, but talks with Lisbon had not begun and would have to wait until a new government was formed.
Portuguese benchmark 10-year bond yields hit new highs on Thursday, climbing to 7.90 percent, far above levels that economists say would allow Lisbon to service its debt.
The euro has remained strong through the latest bout of turmoil, rising steadily for the past two months. It recovered on Thursday after early weakness, trading at $1.4135.
Lisbon needs to refinance about 4.5 billion euros of debt in April and a similar amount in June, which may prove a trigger for finally making the request for aid. One problem is that any bailout request would have to be approved by parliament and the majority is opposed to asking for help.
Asked if a bailout was likely, Eurogroup chief Jean-Claude Juncker said: I do not exclude it.
European leaders surprised markets with what looked like a strong agreement at a March 11 meeting on a range of anti-crisis measures that they were expected to rubber-stamp at the summit this week. But key elements have been unraveling ever since.
Draft conclusions drawn up ahead of the meeting showed a decision on how to increase the effective lending capacity of the bloc's current bailout fund -- the European Financial Stability Facility -- would be delayed until mid-year, probably ahead of a summit in late June.
While a technical issue -- it centers on whether euro zone member states will provide capital or guarantees to raise the effective capacity of the EFSF from 250 billion euros to the full 440 billion -- it risks undermining market confidence in EU policymakers' ability to resolve the crisis.
Finland is the main obstacle to a decision, since it has dissolved parliament ahead of elections on April 17 and cannot therefore sign off on a deal. Helsinki opposes using more guarantees to increase the effective size of the EFSF.
A new Finnish government is only likely to be formed by May at the earliest, and that government may include the eurosceptic True Finns party, which wants to renegotiate the EU's proposed crisis steps, further complicating the outlook.
Over the last few months, EU leaders have made considerable progress in putting together the crisis package.
They have decided in principle to expand the EFSF, agreed to create a permanent crisis fund -- the European Stability Mechanism -- to replace the EFSF from 2013, and agreed to strengthen economic coordination and increase productivity.
But as well as being unable to agree on exactly how the EFSF's capacity should be increased, there are doubts about how they will finance the 500 billion euro ESM using paid-in capital, callable capital and guarantees.
Merkel is demanding changes to an ESM funding deal that her finance minister signed off on at the start of the week.
That deal would have limited her ability to push through tax cuts before the next federal election in 2013 by obligating Berlin to pay 11 billion euros into the ESM that year.
While this is another point of detail, it contributes to a sense in financial markets that EU member states are endlessly at odds over how best to handle the debt crisis.
The summit is also unlikely to make progress on reducing the interest rate on bailout loans extended to Ireland.
Dublin says the rate is so high that it cripples the Irish economy, but agreement on cutting it has been held up by Dublin's refusal to give in to pressure for Ireland to raise its low corporate tax rate and questions about whether Irish banks may require more capital than previously thought.
Irish Prime Minister Enda Kenny said he would await the results of stress tests on the Irish banks due at the end of the month to know the true level of liabilities before any fresh negotiation with euro zone partners on the 85 billion euro bailout Dublin got last November.
(Reporting by Marc Angrand, Rex Merrifield, Jan Strupczewski)
(Writing by Noah Barkin, Luke Baker and Paul Taylor, editing by Mike Peacock)