The downgrading of freshly bailed-out Portugal's credit rating to junk shocked financial markets on Wednesday and cast new doubt on European efforts to rescue distressed euro zone states without debt restructuring.

The cost of insuring all weaker euro zone countries' debt against default rose and Portuguese two-term bond yields spiked by a whole percentage point on Moody's decision, announced late on Tuesday, to cut Portugal by four notches.

The euro and European shares fell on the news, ending a seven-day stocks rally, and Portugal had to pay more to sell 3-month T-bills on Wednesday.

The thumbs-down, coming so soon after a new center-right Lisbon government announced austerity plans going beyond those demanded by international lenders, again called into question the EU strategy for dealing with the euro zone sovereign debt crisis.

Moody's said Portugal may need a second round of rescue funds before it can return to capital markets, just as European governments and banks are haggling over a second 120 billion euro bailout for Greece, which has a much higher debt ratio.

The key worry of the market is that the events that we've been seeing with Greece are being repeated with Portugal, said WestLB rate strategist Michael Leister.

IRELAND TOO?

Ireland, the other euro zone country to have received a bailout, said on Tuesday it may have to make additional spending cuts next year to meet deficit reduction targets in its 85 billion euro bailout plan due to an economic slowdown.

A Reuters analysis last week found that Dublin may also need a second bailout because it is unlikely to grow fast enough to make the envisaged full return to market funding in 2013.

Moody's cited the European Union's management of the crisis, and specifically the attempt to make private creditors share the burden of all future rescues as one reason for its steep downgrade.

The demand that banks and insurers share the risk is driven by growing public hostility in north European creditor nations to any further bailouts for south European states seen as having lived beyond their means.

But Moody's said insisting on private sector involvement not only increased the economic risk facing current investors, but also may discourage new private sector lending going forward and reduce the likelihood that Portugal will soon be able to regain market access on sustainable terms.

BANKERS FACE OBSTACLE COURSE

Representatives of Greece's major creditor banks were meeting in Paris under the aegis of the International Institute of Finance (IIF), a banking lobby, to discuss the terms of a proposed rollover of privately held Greek debt.

Banking sources said numerous issues involving credit ratings, interest rates, maturities and accounting consequences remained to be ironed out among multiple stakeholders and an agreement was only likely in September.

Credit ratings agencies have warned they would be likely to treat any voluntary rollover of Greek bonds as a distressed debt exchange and declare it, at least temporarily, to be a selective default.

European leaders' response has been to criticize the ratings agencies rather than reconsider their policy of seeking at all costs to avoid a debt restructuring.

German Chancellor Angela Merkel brushed aside on Tuesday a warning by the world's biggest ratings agency, Standard & Poor's, that it would view the current French plan for a partial rollover by banks of maturing Greek debt as a default.

It is important that the troika (EU, IMF and European Central Bank) do not allow their ability to make judgments to be taken away, she said. I trust above all the judgment of these three institutions.

Germany's deputy finance minister told Reuters it was absolutely premature to discuss a second rescue package for Portugal and Berlin was confident the country could implement its reforms and get back on track.

There is a new government in place so I would really suggest giving the government the time to do what the new government has promised, Joerg Asmussen told Reuters Insider TV.

We are confident they are willing and able to implement the first package and get back on track, he said.

New French Finance Minister Francois Baroin was just as dismissive of Moody's action on Portugal.

A ratings agency's view is not going to solve the matter of tension on sovereign debt markets and the budgetary crisis, he said, adding he trusted Portugal's new government to meet its deficit reduction target by 2013.

SELF-FULFILLING?

EU officials complain that the ratings agencies' downgrades are a self-fulfilling prophecy, making it harder for countries under assistance programs to return to capital markets.

Underlying the debate is an increasingly prevalent view in financial markets -- disputed publicly by EU governments -- that Greece, and possibly also Portugal and Ireland, will have to restructure debt sooner or later and force significant losses on bondholders.

The more widespread that assumption becomes, the harder it will be to negotiate further official funding for Greece.

The International Monetary Fund board is expected to approve on Wednesday the release of a vitally needed fresh tranche of loans for Greece after euro zone finance ministers agreed on Saturday to pay their share.

But IMF sources say disquiet is growing among non-Europeans at the global lender over the risks of pouring more money into Europe's debt crisis with no resolution in sight.

It goes to show that this whole crisis isn't over just yet. Even if they cough up some more money for Greece, and that looks like it's a done deal, it's not over, said Jay Bryson, global economist at Wells Fargo Securities.

I would think it's bad news for Spain and Italy as well.

(additional reporting by Ana Nicolai da Costa, Naomi Tajitsu and Alex Chambers in London, Walter Brandimarte in New York, Eva Kuehnen, Annika Breidthardt and Gernot Heller in Berlin and Leigh Thomas in Paris; writing by Paul Taylor, editing by Janet McBride)

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