Ratings agency Moody's warned Spain it could be downgraded and frustration at Germany and France over their handling of the euro zone debt crisis boiled over on Wednesday, ahead of a European Union summit.
Moody's said it was concerned about Spain's high funding needs and its indebted banking sector, but that it did not expect Madrid to have to resort to an EU bailout like Greece and Ireland. The euro briefly weakened on the news.
Spain, which with Portugal has come under intense market pressure in recent weeks, raising concerns that it could be driven into a bailout, needs to refinance around 60 billion euros of debt early next year, according to JP Morgan research.
Both the cost of insuring Spanish debt against default and yields on its 10-year bonds rose on Wednesday, with the spread over German bunds rising 7 basis points to 260, an indication of the increased risk attached to Spain.
EU leaders meet in Brussels on Thursday and Friday for their end-of-year summit, with the region's year-long debt crisis and efforts to better tackle it the central issues on their agenda.
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 leaders will discuss how they can improve the current temporary crisis resolution mechanism -- 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.
We have to give a clear signal that we won't let any European country down, he told Belgium's De Standaard.
DEFENDING THE EURO
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.
European Commission President Jose Manuel Barroso urged leaders to act fast to reach a consensus, but some euro zone states voiced frustration at Germany and France who, as the motors of the EU economy, often dominate decision-making.
I can only warn Germany and France against making a claim to power, which reflects a certain haughtiness and arrogance and disregards the European principle of solidarity, Luxembourg's foreign minister, Jean Asselborn, told the newspaper Die Welt.
Germany will understand that their theatrical performances of the past months are of no use.
He said Paris and Berlin had a tendency to blow up problems ahead of EU summits, only to resolve them at the meetings.
EU diplomats have worked to finalize as many outstanding issues as possible ahead of the summit so that discussions can focus on crisis resolution. Officials fear that a lack of concrete action will be exploited by financial markets when trading picks up again next year.
The European Central Bank holds a regular, non-policy 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 Governor 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 European Central Bank 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.
One euro zone central bank source said the ECB was eyeing a doubling of its subscribed capital of almost 5.8 billion euros, which compares to a balance sheet of 138 billion euros, according to its latest annual report.
After nearly a year of tackling relentless debt problems, EU leaders are hoping that the lull in financial markets over the past two weeks will stretch into 2011. But that may be wishful thinking, with pressure points on the horizon.
Portugal will hold its last debt auction of the year on Wednesday, offering 750 million euros of three-month treasury bills. If it has to pay a punitively high yield to raise the funds, it could prompt wider market concerns.
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.
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 bonds, or e-bonds, which would effectively mean the 16 euro zone countries sharing credit risk and debt issuance.
Germany is rigidly opposed to the proposal, which 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.
Barroso told the European Parliament: Eurobonds in themselves are an interesting idea ... But we are in a crisis situation and we already have financial mechanisms to address that crisis, such as the European Financial Stability Facility.
These are far from exhausted, and can be improved and adapted far more quickly than any alternatives, however interesting they may be.
(Additional reporting by Rex Merrifield and Marcin Grajewski, writing by Luke Baker, editing by Kevin Liffey)