Spain and Italy staged successful bond sales on Thursday, buying European leaders a little time to come up with a new package of measures to stem the debt crisis rocking their 12-year old single currency bloc.
A day after Portugal surprised many in the markets by selling 10-year debt relatively easily, Spain and Italy passed their first major financial tests of 2011, auctioning a total of 9 billion euros in bonds.
The euro pushed up to its highest level against the dollar in a week and the risk premium investors demand to hold the debt of Spain, Portugal and Italy instead of Germany fell, in a sign that investors are growing more confident about the bloc's ability to address its economic woes.
The European Central Bank left its record low interest rates unchanged and the bloc's leaders reiterated their pledge to do whatever was necessary to stabilize the 17-nation currency area.
The euro zone members, and especially France and Germany, are ready to do everything ... absolutely everything to ensure the stability of the euro zone, French Prime Minister Francois Fillon said during a visit to London.
Late on Thursday, German Finance Minister Wolfgang Schaeuble announced that major European states were working on a comprehensive medium-term package to solve a debt crisis some experts believe threatens the future of the bloc.
Top European Union officials are pushing for the bloc to increase the size and scope of the 440 billion euro ($574 billion) rescue fund it agreed to put in place after bailing out Greece in May.
Since then, the EU has been forced to rescue Ireland and concerns have grown that other high-deficit countries like Portugal and Spain could require aid as well.
STEPS TO SOOTHE MARKETS
Both Germany and France have played down the need to boost the fund, known as the European Financial Stability Facility (EFSF), but they are discussing closer fiscal coordination and other steps meant to soothe market fears about the euro area.
One idea that has been floated is to reduce the interest rate demanded of countries that tap the facility.
Another is to allow the EFSF to buy government bonds or provide short-term credits to vulnerable euro members -- ideas that seem to be dividing government ministers in Europe's economic powerhouse Germany.
At a news conference on Thursday afternoon, ECB President Jean-Claude Trichet was expected to press governments to do more to tackle the debt crisis.
The ECB faced pressure last year from euro zone governments to ramp up its purchases of peripheral debt, but it has been cautious in its buying of bonds and remains staunchly opposed to the large-scale quantitative easing pursued by its central bank counterparts in the United States and England.
It did, however, buy Portuguese bonds to ease the path to its auction this week.
Spain sold 3 billion euros of 5-year bonds on Thursday at a yield of 4.54 percent -- nearly a full percentage point more than at a previous auction in November but well below the level some had feared.
Demand was robust with over 6 billion euros in bids and 60 percent of the debt was bought by investors outside of Spain, a source told Reuters.
Shares in large Spanish banks, whose own debt levels and exposure to a collapsed property market have worried markets, shot higher for a second day, with Banco Santander trading up 3.2 percent and BBVA rising 5.3 percent.
But in a reminder that Spain's financial woes are far from resolved, retail bank Banesto announced its profit had tumbled nearly 20 percent last year on bad loans and a price war for deposits.
Like Spain, Italy saw yields rise as it sold 6 billion euros in 5- and 15-year bonds, but demand was stronger than its last sale in November.
Italy has largely avoided the wrath of the bond markets, but is seen as vulnerable due to its high debt levels.
GERMAN STANCE CRUCIAL
Investors were cheered on Wednesday when German Chancellor Angela Merkel vowed, at a news conference in Berlin with visiting Italian Prime Minister Silvio Berlusconi, to do whatever was necessary to safeguard euro zone stability.
But her center-right government may be reluctant to commit to bold new steps before state elections in Hamburg and Baden-Wuerttemberg in the coming months, given that German voters are deeply skeptical about helping out euro zone debtors.
She might also have to go to parliament to secure its approval for any substantial increase in the EFSF, whose legality is being challenged in Germany's top court by several eurosceptic academics.
Hans-Werner Sinn, the influential head of the Ifo research institute in Munich, warned against boosting the fund in an interview with the Handelsblatt daily on Thursday, likening such a move to the Irish government's disastrous blanket guarantee of bank debts -- a key factor in forcing Dublin's bailout.
(Additional reporting by Christiaan Hetzner; Writing by Noah Barkin; Editing by Ruth Pitchford)