Portugal's financial plight deepened Wednesday, with borrowing rates jumping higher and stocks slumping after its bonds were downgraded to junk status. Spain and Italy were dragged into the downturn, adding new momentum to Europe's sovereign debt crisis.
Portugal's hopes of slowly emerging from its debt crisis were knocked by ratings agency Moody's, which downgraded Portugal's debt four notches Tuesday and said the country will likely follow Greece in needing a second rescue package.
Portugal took a euro78 billion ($112 billion) bailout from its European partners and the International Monetary Fund earlier this year after nervous investors began charging it unsustainably steep returns on loans.
After the abrupt worsening of Portugal's financial situation, neighboring Spain immediately suffered a knock-on effect, with Madrid's main stock index down 1.2 percent and bond yields rising. Spain, a much bigger country, until now has managed to dodge major fallout from the continent's fiscal woes.
The jitters were even felt in Italy, where stocks were down 2.4 percent on concerns that spending cuts might not be enough to bring down high debt.
The idea that the crisis might grow to engulf larger economies is a looming threat for markets. Rescuing Spain and Italy would be many times more expensive than all the bailouts the EU has paid for so far.
"The increasing risk is Italy gets caught up further in the contagion, and the bond market vigilantes dictate a more abrupt pace for its adjustment," said Alan Ruskin, an analyst at Deutsche Bank.
The Moody's downgrade _ viewed by some analysts and officials as unexpectedly harsh _ triggered new outrage in Portugal, where austerity measures over the past year have included tax hikes, pay freezes and welfare cuts.
Portuguese Prime Minister Pedro Passos Coelho said the downgrade was "like a punch in the stomach." Fernando Faria de Oliveira, the head of Portugal's largest bank, the state-owned Caixa Geral de Depositos, called it "immoral and insulting."
Even Barclays Capital Research said the severity of the downgrade was surprising, adding it "seems more like a reaction to the Greek situation."
The tensions were nevertheless reflected in a Portuguese bond sale. Although the national debt agency managed to raise euro848 million ($1.2 billion) from markets, investors demanded a high return. The yield in the sale of 3-month Treasury bills was 4.926 percent _ up from 4.863 percent on the same bills in mid-June and not far from the record 4.967 percent on June 1.
The yield on Portuguese 10-year bonds surged to 13 percent, while the Lisbon stock exchange fell 3 percent with banks recording the steepest drops.
Part of Moody's rationale for the downgrade was that the EU's determination to get private sector investors to share the burden of bailouts, as being discussed for Greece, increases the chances of Portugal being shut out of the market beyond 2013, when it hopes to resume bond issues.
European Commission President Jose Manuel Barroso said Portugal's recovery program will be adequately monitored and assessed by the European Central Bank and the IMF, with an interim report due in the fall.
"In this context, and the absence of new facts on the Portuguese economy that could justify a new assessment, yesterday's decisions by one rating agency do not provide for more clarity. They rather add another speculative element to the situation," Barroso said in Strasbourg.
German Finance Minister Wolfgang Schaeuble expressed surprise, too, saying in Berlin, "I ... cannot see what this decision is based on."
Schaeuble said Portugal "is not only fully on course but even ahead of the curve" in implementing the bailout measures. "That means there is, from our point of view, no basis ... for such an assessment, at least at this early stage," he said.
Portugal nevertheless faces a daunting task in reducing its debt load _ it is in a recession, with its economy expected to contract 4 percent through next year, and unemployment stands at a record 12.4 percent.
A center-right coalition government that took office last month has promised to abide by debt targets and economic reforms demanded in return for the bailout. It has already introduced new austerity measures, including a one-off supplemental tax on personal income this year, and said it would accelerate a privatization program.
The government debt agency said last week it wants to raise up to euro6.5 billion in Treasury bill auctions over the next three months.
In Spain, the next market test will come Thursday, when the Treasury will auction off three- and five-year bonds.
Ciaran Giles in Madrid, Gabriele Steinhauser in Brussels, Colleen Barry in Milan and Geir Moulson in Berlin contributed to this report.
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