Ratings agency Moody's warned Spain on Wednesday its credit rating could be downgraded, highlighting concerns about euro zone debt contagion on the eve of a European Union summit.
Moody's said it was concerned about Spain's high debt funding needs, its heavily indebted banks and its regional finances, but it did not expect Madrid would have to follow Greece and Ireland in seeking an EU bailout.
Spain and Portugal have now come under intense market pressure, raising concerns they could be driven into seeking an emergency rescue when they hit funding crunches next year.
The cost of insuring Spanish debt against default and yields on its 10-year government bonds rose on Wednesday, an indication of the increased risk attached to Spain. The euro fell against the dollar and European stocks lost ground.
Europe remains very fragile. Everyone sees a major crisis in the first few months of 2011 that would coincide with Spain's refinancing operations, said Arnaud Poutier, deputy head of IG Markets France.
Spanish Economy Minister Elena Salgado said market movements were being exaggerated by thin volumes at year-end, but that it also made sense to enlarge a European financial rescue fund to make sure it could tackle the crisis.
EU leaders meet in Brussels on Thursday and Friday for their end-of-year summit, with efforts to overcome the region's year-long debt crisis at the center of their agenda.
They also face protests over austerity policies announced by governments across Europe to repair their public finances.
Greek protesters clashed with police and set fire to cars and a hotel as tens of thousands of people marched through Athens. Riot police fired dozens of rounds of teargas and hooded threw sticks and stones.
Irish Prime Minister Brian Cowen won parliamentary support for Dublin's 85 billion euro ($113.2 billion) IMF/EU bailout on Wednesday, clearing the way for the IMF to approve the first disbursement later this week.
But opposition parties voted against the terms of the rescue package and vowing to unpick them if, as expected, they oust Cowen's unpopular government at an early election next year.
The main opposition party Fine Gael party said it felt no moral or legal obligation to honor all Irish banks' debts to bondholders and would try to renegotiate the interest rate on the EU/IMF loans.
Finance Minister Brian Lenihan said it was frankly laughable for the opposition to suggest it could negotiate a better interest rate than the 5.8 percent set in the deal.
As well as approving a change to the EU's treaty demanded by Germany to create a permanent system for handling crises from mid-2013, the EU leaders will discuss how they can improve the current temporary financial safety net -- a 750 billion euro ($1 trillion) joint EU/IMF loan facility.
One possibility is to increase the size of the fund.
Belgian Finance Minister Didier Reynders said the EU's portion, 440 billion euros, could potentially be doubled to fend off the threat of renewed market pressure on Portugal and Spain, and Spain's Salgado backed the idea of a larger fund.
What we think is reasonable is that the real capacity of the fund coincide with the theoretical capacity, she said, pointing out that while it is 440 billion euros in theory, credit guarantees make it smaller than that in practice.
The EU's leading powers, Germany and France, says less than 10 percent of the rescue funds have been committed so far, so there is no urgent need to increase the money available.
German Chancellor Angela Merkel said no country in Europe would be left on its own, and reiterated that the euro was a strong currency that would be defended to the hilt.
We know that the euro is our collective destiny, and Europe is out collective future, Merkel told parliament. Nobody in Europe will be abandoned. Europe will succeed together.
European Commission President Jose Manuel Barroso urged leaders to act fast to reach a consensus.
EU diplomats have worked to clear the decks of outstanding issues before the summit so that discussions can focus on crisis resolution. Officials fear financial markets may seize on a lack of concrete action when trading picks up again next year.
The European Central Bank holds a regular, non-rate setting meeting on Wednesday and Thursday, when it is expected to agree to ask euro zone member states for more capital, a move to lower its leverage as it helps tackle the debt crisis.
That issue may be discussed among EU leaders on Thursday, when they will be joined for dinner by ECB President Jean-Claude Trichet. The ECB has come under pressure to step up its bond-buying program to help the likes of Ireland, Greece and Portugal, who are struggling to fund themselves in the market.
ECB CAPITAL BASE
Germany said it would support giving the ECB more capital, with an official saying a bigger base would show financial markets that the central bank had the firepower to buy new government bonds if needed.
Portugal held its last debt auction of the year on Wednesday, selling 500 million euros of three-month treasury bills, but at a punitively high yield of 3.4 percent. Last month it sold the same amount at 1.8 percent.
Belgium, which saw the outlook on its sovereign debt lowered by Standard & Poor's on Tuesday, with the threat of a downgrade within six months, is also a growing concern for policymakers. And Spain's regional banks have yet to resolve all their debts.
Top EU officials, including Luxembourg Prime Minister Jean-Claude Juncker and the Italian finance minister, have called for the euro zone to consider issuing collective treasury bonds, or e-bonds, which would effectively mean the 16 euro zone countries sharing credit risk and debt issuance.
Germany opposes the proposal, which would expose its credit risk to the influence of riskier peripheral euro zone countries such as Portugal and Greece. The issue may be raised at the EU summit, but no decisions are expected.
(Additional reporting by Rex Merrifield and Marcin Grajewski in Brussels and Brian Rohan and Annika Breidthardt in Berlin, writing by Luke Baker and Timothy Heritage, editing by Kevin Liffey and Paul Taylor)