By Angeliki Koutantou and William James
ATHENS/LONDON (Reuters) - Moody's slashed Greece's credit rating by three notches on Monday due to an increased default risk, raising the specter that the distressed euro zone sovereign may have to restructure its debt, perhaps before 2013.
The move increased pressure on euro zone leaders to ease repayment terms on bailout loans to Athens, just as Germany and its allies seem to have turned their backs on more radical steps to help it reduce its debt through bond purchases or buy-backs.
Moody's Investors Service downgraded Greek debt to B1 from Ba1 -- lower than Egypt -- and said it may cut further, drawing an indignant protest from the Greek Finance Ministry.
"The likelihood of a default or distressed exchange has risen since its last downgrade of the Greek government debt rating in June 2010," Moody's said in a statement.
The downgrade sent a ripple of anxiety around credit markets, raising the price of insuring Greek, Portuguese and Spanish debt against default and the risk premium on holding Greek bonds rather than benchmark German bunds.
Portuguese government bond yields hit a euro lifetime high of 7.65 percent, heightening pressure on Lisbon to seek an EU/IMF bailout in the wake of Greece and Ireland.
Ahead of a euro zone summit on Friday, European Monetary Affairs Commissioner Olli Rehn made the case for reducing interest rates paid by Athens and Dublin on euro zone rescue loans and extending the maturities to enable them to achieve debt sustainability.
Moody's cited risks to Greece's fiscal consolidation program from a revenue shortfall and difficulties in reforming healthcare and state-owned companies.
Greece signed a 110 billion euros ($154 billion) rescue package with the EU and IMF last May to avoid default in exchange for draconian austerity measures which it has begun to implement. But many see the repayment terms as too onerous.
"The sheer magnitude of the task becomes ever more apparent," said Sarah Carlson, Moody's lead analyst on Greece.
Even if it fulfils the entire three-year adjustment program, its debt is projected to reach 158 percent of gross domestic product in 2013, a level widely seen as unsustainable.
"There is a risk that conditions attached to any kind of continuing support after 2013 could take solvency criteria into account that the country may not be able to satisfy, and therefore could result in a restructuring of existing debt," Carlson told Reuters.
The European Central Bank, which has intervened repeatedly since last May to calm bond markets by buying euro zone peripheral sovereign debt, said it made no purchases last week in the run up to Friday's euro zone summit.
Moody's was the first of the three major ratings agencies to classify Greek debt as "highly speculative."
The Greek Finance Ministry said it had ignored progress in implementing its fiscal consolidation plan, including an improvement in revenue collection.
"Decisions such as Moody's today can initiate damaging self-fulfilling prophecies," it said.
However, some analysts said the bond market was already pricing in a managed Greek default.
"This is not going to be the last downgrade for Greece," said Christoph Weil, an economist at Commerzbank. "The market has already discounted that Greece will need to restructure its debt so the rating agencies are just running behind the market."
On Friday, euro zone leaders will discuss measures to enforce stricter budget discipline, boost economic competitiveness and strengthen the bloc's financial rescue fund in an attempt to draw a line under the debt crisis.
Rehn said there was a case for lowering the interest rate on both Greek and Irish loans and giving them longer to repay.
"The issue now and tomorrow is debt sustainability, and therefore I can see that there is a case to reduce the interest rates paid by Greece and Ireland," he told reporters.
"In that context, it is important that we also look at loan maturities so that we can go beyond the hump of 2014 and 2015 and that also contributes to debt sustainability."
Germany, the EU's reluctant paymaster, has hinted it may agree to extending the maturity of Greek loans to seven years, like Ireland's, and possibly ease the interest rate slightly.
But Berlin's ruling center-right coalition parties and the Bundesbank have strongly opposed any purchase of distressed sovereign bonds by the euro zone rescue fund and any lending to Greece to buy back its own debt on the market at a discount.
Moody's said it was concerned by the lack of certainty about the nature of financial support that will be available to Greece after 2013, and its implications for bondholders, although its central scenario remains that bondholders will not bear losses.
Private economists see losses for investors as more likely in the longer term.
"We expect, not immediately but in the coming years, that more measures will be needed, maybe even a haircut," said Juergen Michels at Citigroup.
The spread on 10-year Greek debt against benchmark Bunds widened by 8 basis points following the Moody's downgrade, which came amid intense negotiations among euro zone countries on a package of measures intended to overcome the sovereign debt crisis that has shaken the currency bloc since November 2009.
Center-right leaders meeting in Helsinki last Friday agreed in principle to increase the effective lending capacity of the temporary European Financial Stability Facility and review the loan conditions to Greece and Ireland.
But Germany, Finland and the Netherlands opposed allowing the rescue fund to buy bonds or to lend distressed countries money to buy their own bonds, participants said.
Some EU officials see the hardline stance as pushing Greece toward restructuring, but only after west European banks have had time to raise their capital base to cope with the fallout from potential Greek losses.
(Additional reporting by Emile Sithole-Matarise, Marius Zaharia and Brenda Goh in London, Terhi Kinnunen and Andreas Rinke in Helsinki; writing by Paul Taylor, editing by Mike Peacock)