Moody's adds to euro-zone woes

Officials are working on the broad outlines of a three-pronged agreement to keep the debt crisis from spiralling into Europe's large countries. They have been giving serious consideration to increasing the size of a new euro zone bailout fund of ?440 billion ($A593 billion) to at least ?1 trillion to ?1.5 trillion.

Europeans are also discussing recapitalising many European banks as insurance in case the crisis worsens, as well as forcing banks to take sizeable losses on their holdings of Greek debt to help the country get back on its feet.

Moody's Investors Service cut Spain's credit rating by two levels to A1 from Aa2, with the outlook remaining negative.

Moody's cited the "continued vulnerability of Spain to market stress" that was driving up the cost of borrowing, as well as weaker growth prospects.

"Moody's is maintaining a negative outlook on Spain's rating to reflect the downside risks from a potential further escalation of the euro area crisis," the agency said.

"Even if policy action at the euro-area level were to succeed in the short term in returning some degree of normality to bank and sovereign debt markets in the euro area, the underlying fragility and loss of confidence is deep and likely to be sustained."

Spanish, Italian and Greek bonds fell yesterday on concern that the euro zone is struggling to contain the turmoil as banks faced with rising defaults lack the capital to absorb a shock in sovereign debt.

German Chancellor Angela Merkel said yesterday a European Union summit on Sunday would mark an "important step", though not the final one, in solving the euro zone sovereign debt crisis.

Government discussions have taken on greater urgency since Moody's warned on Monday of a possible downgrade to France's flawless credit rating.

French finance officials worry that any such move would make it hard for Paris to negotiate solutions, according to a source.

The rally in US stock markets was set off by a report in The Guardian that France and Germany had agreed to increase the size of the rescue fund the European Financial Stability Facility to as much as ?2 trillion to contain the crisis and backstop Europe's banks.

But almost as soon as those hopes soared, European officials quickly brought them back to earth, with denials from Brussels, Paris and Berlin.

This latest round of rumours and rebuttals about a European solution was a repeat of earlier situations.

Such episodes have played out several times since the debt crisis intensified this year. Most recently, investors have been pegging hopes on the meeting of Europe's leaders in Brussels on Sunday, anticipating that a comprehensive solution to the debt crisis might be unveiled.

Fuelling those hopes had been impressions given last weekend in Paris at a meeting of G20 finance ministers that a grand plan was forthcoming. Those conveying such signals included the French Finance Minister, Francois Baroin.

On Monday, though, Dr Merkel quickly brought things back to reality, warning that "dreams" of a package that would immediately resolve the problems were unrealistic.