European leaders sought to paper over deep divisions on how best to resolve the debt crisis ahead of a summit on Thursday, and Spain and Portugal came under renewed pressure to get their finances in order.

German Chancellor Angela Merkel said she had settled a dispute with Jean-Claude Juncker, the chairman of the Eurogroup of countries, over the idea of issuing euro area bonds, but differences still looked likely to arise at the summit.

Jean-Claude Juncker and I had a long telephone conversation and cleared up the issue a while ago, Merkel said in an interview with Germany's Bild newspaper published on Thursday. With so much at stake, the emotions sometimes get involved.

Juncker, who is a strong advocate of issuing so-called E-bonds, which Merkel says are unnecessary and would dent Germany's credit standing, also said the disagreement was resolved, but has hinted he could raise the proposal anyway.

He said he regretted dissonances in public which had given financial markets more cause for concern, and said he was focused on trying to achieve unity ahead of the two-day summit, as well as getting Spain and Portugal to improve their finances.

They would do well... to present in detail structural reforms to be introduced beyond the plans of consolidation already announced, he told Corriere della Sera.

DOWNGRADE THREAT

Ratings agency Moody's warned Spain on Wednesday that its debt could be downgraded, saying it was worried about its high debt funding needs, indebted banks and regional finances, although it did not expect Madrid to have to follow Greece and Ireland in seeking an EU bailout.

Spain's Treasury paid just slightly less than expected for long-term bonds on Thursday in a key test of investors' appetite for euro zone peripheral debt and a day after Moody's said it may cut the country's rating.

Portugal on Wednesday announced extra measures to cut red tape and bolster structurally slow growth, in a move to convince EU officials and financial markets it is doing enough to stave off the pressure to seek EU financial aid.

EU leaders will gather at 1500 GMT on Thursday for the end-of-year summit, having spent most of 2010 desperately trying to stem a contagion that has consumed Greece and Ireland and now threatens Portugal, Spain and others.

Apart from agreeing to make a small change to the EU's treaty to set up a permanent system for handling financial crises after 2013, they are not expected to take other concrete decisions, inaction that could be interpreted as weakness and exploited by financial markets unconvinced by the euro zone.

Throughout 2010, EU leaders have struggled to show unity and clear communication in handling the crisis, either putting forward half-formed or contradictory proposals, or not agreeing quickly enough on the right course of action.

Repeated statements of unity at half-a-dozen summits have sometimes not been backed up by action, leaving markets skeptical and piling more pressure on the euro and debt yields.

TREATY CHANGES, ECB CAPITAL

As well as approving the change to the EU treaty, demanded by Germany and backed by France over the opposition of several other member states, EU leaders are expected to discuss how they can improve the current temporary financial safety net -- a 750 billion euro ($1 trillion) joint EU/IMF loan facility.

One possibility is to increase the size of the fund, while another would involve making it more flexible in terms of the loans it can make, including the possibility of credit lines.

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, and Spain has also backed the idea of a larger fund.

While that may be discussed, EU sources indicate that they do not expect a concrete decision on enlarging the fund.

The European Central Bank holds the second day of a regular, non-rate setting meeting on Thursday, when it is expected to agree to ask euro zone member states for more capital, a move to lower its risk profile as it helps tackle the crisis.

That issue may also be discussed among EU leaders on Thursday, when they will be joined by ECB President Jean-Claude Trichet. The ECB has come under pressure to step up its bond-buying program to help those countries struggling to fund themselves in volatile and punitive market conditions.

As well as fears about the debt situation in Portugal and Spain, which has approximately 275 billion euros of sovereign and bank debt expiring in 2011, there are increasing worries about other euro zone member states, including Belgium.

Underlining concerns about the euro zone economy and the strength of its recovery, the dominant services sector expanded at a much slower pace than expected in December, although the manufacturing sector is growing faster than forecast, figures released on Thursday showed.

Switzerland, one of the euro zone's largest trading partners, kept interest rates on hold on Thursday, partly a reflection of the euro-area's difficulties, which have offset strong Swiss economic growth this year.

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