BRUSSELS/ATHENS - The European Commission endorsed Greece's austerity plan on Wednesday but said Athens must take further steps to cut public sector wages to tackle the most severe debt crisis in the euro zone.

In an assessment closely watched by markets weighing up Greece's credibility as a debtor, the European Union executive ordered Athens to submit an interim report on progress in reducing its huge deficit by mid-March.

It said the plan to cut the budget gap from 12.7 percent of gross domestic product (GDP) in 2009 to below 3 percent in 2012 would not be easy to implement, and Greece must be ready to make further deep fiscal adjustments.

If the programme is followed by decisions, by actions ... this will have a positive effect on the market, EU Economic and Monetary Affairs Commissioner Joaquin Almunia told a news conference. If decisions are not there, the markets will be putting additional pressure.

The premium investors demand to hold Greek government bonds rather than benchmark German Bunds fell further after the EU endorsement, as did the cost of insuring Greek debt against default. Greek bank shares were up 2.9 percent.

You'd imagine they'll use any period of sustained strength in the Greek market as an opportunity to issue more paper, a bond trader in London said.

Greece has to refinance 54 billion euros in debt this year, with a crunch in the second quarter as 20 billion euros becomes due. A 5-year bond issue last week was five times oversubscribed but the government had to pay a hefty premium.

Almunia dismissed concerns that Greece's fiscal problems could put the single European currency at risk or require a bailout by European partners to avoid a possible default.

I am fully convinced that the European Union and euro area have instruments enough to deal with this issue and solve this problem (Greece), Almunia said.

Some economists have argued that Greece should seek an International Monetary Fund standby loan to back its adjustment programme and prevent bond market jitters spreading to other weak euro zone economies such as Portugal and Spain.

Spain said on Wednesday it had revised up its budget deficit forecasts for the next three years. It now expects its deficit to total 9.8 percent of GDP in 2010, 7.5 percent in 2011 and 5.3 percent in 2012 -- estimates that are 1.7 to 2.3 percentage points above previous forecasts.

Euro zone countries have been adamant that the EU can handle the matter without IMF intervention, which would be politically embarrassing and imply a failure of the EU's Stability and Growth Pact budget rules.

The Commission recommended Athens adopt a comprehensive structural reform package aimed at increasing the effectiveness of the public administration, stepping up pension and healthcare reform, improving labour market functioning and the effectiveness of the wage bargaining system.

On the eve of the Brussels verdict, Prime Minister George Papandreou went on television to announce fresh savings measures including a fuel tax rise and a wider freeze on public pay, warning Greeks they face the most severe crisis in decades.

Deputy Finance Minister Philippos Sachinidis told Reuters the fuel surcharge should raise an extra 1 billion euros this year and the public wage freeze about 150-200 million euros.

The measures are in response to fierce pressure from financial markets, ratings agencies and EU partners for Athens to take tougher action to slash the deficit while public opinion is broadly supportive.

VIOLENT REACTION?

Trade unions have called a one-day strike this month and markets are concerned that the government may find it difficult to sell harsher austerity measures at home.

Greece's public debt is expected to hit 120 percent of GDP this year. Fears of a possible Greek default have reverberated across the euro zone, hitting the common currency and bond prices and prompting speculation of a bailout plan, which EU officials have denied.

The austerity programme, presented last month, includes welfare spending cuts, tax hikes, non-replacement of departing civil servants and cuts in top-up wages for higher earners in the public sector. But analysts have questioned whether the measures are sufficient to reach the targets.

EU Commission President Jose Manuel Barroso said on Tuesday the plan was feasible but fraught with risks, adding that its success was crucial not just for Greece but for the whole EU.

We still don't know how much these announcements will calm markets down, neither can we estimate how violent the reaction against these measures will be, said conservative daily Kathimerini in an editorial.

Left-leaning Ta Nea daily said Greeks were ready to make sacrifices if they perceived the austerity measures to be fair, but added: There is no doubt that the measures Prime Minister George Papandreou announced will be tough and painful for a lot of people.

(writing by Paul Taylor, editing by Noah Barkin)

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