Ratings agency Moody's warned Spain on Wednesday that its debt could be downgraded and Portugal took steps to revive its economy amid concerns about euro zone debt contagion on the eve of a European Union summit.
Moody's said it was worried 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.
The Portuguese government announced moves to cut red tape and boost growth, and said it would soon adopt quarterly fiscal targets, part of a broad effort to convince EU officials and financial markets it does not need a bailout.
Spain and Portugal have come under intense pressure in bond markets, raising concerns they could be driven into seeking an EU/IMF 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.
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 heart of their agenda.
Jean-Claude Juncker, the chairman of the Eurogroup countries, said he regretted that discord among EU states over how best to handle the debt crisis had led to tensions and probably given markets more cause for concern.
Unfortunately there are dissonances in public, he told Germany's Hadelsblatt newspaper. Juncker and German Chancellor Angela Merkel have publicly disagreed over anti-crisis steps.
Leaders 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 in the largest and most violent anti-austerity protests since May, when three people died.
IRISH BUDGET PASSED
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 International Monetary Fund to approve the first disbursement later this week.
But opposition parties voted against the terms of the rescue package and vowed to unpick them if, as expected, they oust Cowen's unpopular government at an early election next year.
The main opposition party said it felt no moral or legal obligation to honor all Irish banks' debts to bondholders and would try to renegotiate the EU/IMF loans.
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, 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, while another would involve making it more flexible.
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 economy minister backed the idea of a larger fund.
The EU's leading powers, Germany and France, say less than 10 percent of the rescue funds have been committed so far, so there is no urgent need to increase the money available.
Merkel said no country in Europe would be left on its own, and reiterated that the euro was a strong currency.
We know that the euro is our collective destiny, and Europe is our 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 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 Portugal, which is struggling to fund itself 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 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.
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, Paul Taylor and David Stamp)