Portuguese storm gathers as EU leaders fight over Greece

The FTSE 100 fell 1.1pc and Germany's DAX was off 1pc, while the iTraxx Crossover index measuring credit risk in Europe jumped 30 points to 637. Yields on Italian 10-year debt rose 21 points to 6.08pc.

The worries over Portugal continued to mount even as German Chancellor Angela Merkel backed away from demands for a European austerity commissioner to take control of the Greek budget, averting an explosive clash with Athens.

"We don't want controversial talks, but a discussion that is successful for the Greek people," she said, insisting that Germany's plan was just one many of options.

The change of tack came after Berlin's allies in the northern creditor bloc warned such heavy-handed diplomacy had become offensive and breached the spirit of the EU project.

"You never stoop to insults in politics. It solves nothing," said Austria's Chancellor Werner Faymann. Luxembourg's foreign minister Jean Asselborn said it behoves Europe's most powerful state to display a "little more caution", advising Germany to "watch out" as passions grow stronger.

The dispute overshadowed the summit, intended to promote EU growth and tackle youth unemployment – now 22pc Europe-wide and 51pc in Greece. Talk of growth at a time when EU austerity has entrenched severe slumps across southern Europe has left markets bewildered.

While EU leaders fleshed out a German-inspired "fiscal compact" to police the budgets of EMU states, Finland called it "at best unnecessary and at worst harmful" while Luxembourg deemed it a "waste of time". The pact has been weakened, allowing a breach of the new structural deficit limit of 0.5pc of GDP in a wider range of circumstances.

On Monday night, 25 of the 27 EU nations signed up to the fiscal compact, with the Czech prime minister joining the UK in staying outside the deal.

While German calls for an EU commissar for Greece are not new, the aggressive tone of the draft shocked EU veterans. It stipulated that Athens must give "absolute priority to debt service", "transfer national budgetary sovereignty", and agree to terms that make it impossible for Greece to "threaten lenders with default". Furious Greek leaders rejected the terms as debt servitude.

Analysts have questioned whether Germany deliberately called for conditions that Athens cannot accept, perhaps to force Greece's withdrawal from the euro and set an example to others.

The softening of the German stance does not in itself settle the Greek crisis – even assuming Athens agrees soon to a deal with private creditors for debt relief near 70pc. Greece will almost certainly need a further €15bn on top of the €130bn package in force, yet Mrs Merkel has warned that Germany will not provide any further funds.

Jacques Cailloux from RBS said there would be a chain reaction if the troika halts payments and sets in motion a Greek default and exit from EMU.

"That would the disaster scenario. Those who think this could be contained don't know what they are talking about. There would be extraordinary contagion, as we are already seeing in Portugal, spreading back to Spain, Italy, and France," he said.

Citigroup thinks Portugal's economy will contract by 5.7pc this year and 3.5pc next year, replicating the downward spiral seen in Greece as austerity began to bite.

While Portugal has delivered on its promises, the task may be Sisyphean with a combined public and private debt of 360pc of GDP – 100 percentage points higher than in Greece. Grit alone cannot overcome the same chronic lack of competitiveness.

Europe's leaders have vowed that they will not inflict a "haircut" on Portugal's creditors, insisting that Greece is a "special case". The relentless exodus from Portuguese debt suggests that investors do not believe them.

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Spain downgrade sparks storm over rating agencies

The central bank said on Thursday that 12 cajas (savings banks) and other banks must raise €15.2bn between them by September, led by Bankia (€5.8bn), Novacaixagalicia (€2.6bn), and Catalunyacaixa (€1.7bn).

Moody's praised Spain for its market reforms and said "debt sustainability is not under threat." But it also warned of fresh "episodes of funding stress". The government, regional juntas, and banks must together must raise or roll over €300bn of debt this year.

Fitch Ratings also issued a report concluding that the bail-out costs might spiral, putting the figure at €97bn in an Irish-style "stress scenario" where property losses reach 58pc. The Irish parallel has infuriated Madrid since delinquency rates on Spanish homes are low. Loan-to-value ratios on mortgages average just 62pc.

Spanish officials said it was astonishing that Moody's should drop its bombshell hours before the central bank was due to publish its own far more detailed analysis. "Moody's don't explain how they come up with these numbers," said one source.

European anger over the power of "Anglo-Saxon" rating agencies has been welling for months but has now reached fever pitch. Greece's finance minister George Papaconstantinou wrote on Thursday to the EU authorities calling for restraining action after Moody's cut Greek debt three notches three-notch. "Such unjustified and imbalanced decisions could become self-fulfilling prophecies. Rating agencies must be regulated effectively at a European and world level," he said.

Brussels is drawing up tougher rules, perhaps making Moody's, Fitch, and S&P liable for the damage of "incorrect ratings". An EU source said it was scandalous that one agency had rated Greece by sending a single person to the country twice a year for a half a day. "When the IMF goes in, they send a whole team for a week. We want to know how much serious time and effort goes into these ratings."

Spanish officials feel aggrieved that they are being punished after taking the lead in eurozone bank reform, going beyond Basel III rules with earlier compliance and requirements for core Tier I capital of 10pc for some banks with a reliance on wholesale funding. Indeed, the ECB even warned in its monthly bulletin that Spain is perhaps too "ambitious", creating the risk of a credit squeeze .

For all the fury over Moody's, Spain undoubtedly faces an ordeal by fire as the ECB prepares to raise rate rises as soon April. One-year Euribor rates used to set the cost of most Spanish mortgages and corporate loans have surged to 1.95pc since the ECB shift, part of an instant tightening effect rippling through Spain's economy. This is potentially threatening. Private debt is near 240pc of GDP.

Julian Callow from Barclays Capital said Spanish house prices are falling steeply after a lull late last year, with the Fotocasa index falling at 5.2pc rate. "Spain has suffered a series of negative shocks, with energy costs going up and no magic package yet in sight from the EU. The ECB should not be rushing into monetary tightening at this moment, The more property prices fall, the more strain this puts on banks," he said.

EU officials are playing down hopes of an EU deal on Friday. A draft "Pact for the Euro" – an enhanced Stability Pact – has been watered down to meet the furious objections of several states and may not be enough to satisfy German demands for Teutonic rigour.

However, it still includes plans for a "debt-break" along German lines that is constitutionally "binding" on all states, as well as intrusive rules on pensions, collective-bargaining, labour costs, and wage indexation.

It empowers the European Commission to vet rules "before" they have been approved by national parliaments. This treads on sensitive toes. The power to tax, borrow, and spend is the essence of national sovereignty. While the document states that the "prerogatives of national parliaments" should be respected, it is far from clear how these can be reconciled.

EU diplomats say the implicit quid pro quo is that Club Med must accept this straight-jacket to secure German backing for a more muscular bail-out fund (EFSF). Yet it is unclear whether Chancellor Angela Merkel can offer meaningful concessions, given a broad-based revolt by Germany's Bundestag, Lander, and academia.

Mrs Merkel is likely to block plans to let the bail-out fund buy eurozone bonds, since this would usher in fiscal union by the back door. Nor does she seem willing to cut the penal rate of interest on the Irish and Greek rescue by enough to make any difference. Capital flight from the eurozone is likely to gather pace if none of these changes are agreed this month. This risks raising the stakes for Spain, and perhaps Italy.

The yield on Italian 10-year bonds pushed above 5pc on Thursday, a level that could start to endanger debt sustainability given the catatonic state of the economy and the sheer size of Italy's public debt at 120pc of GDP. Italy's industrial output fell 1.5pc in January, and has barely recovered from the Great Recession.

Bundesbank chief Axel Weber said that Germany's rebound should not be exaggerated. The growth speed on the economy is just 1pc over time. "Europe will become more and more insignificant in the global economy," he said.

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