BERLIN/PARIS (Reuters) - Germany and France said on Monday that Europe had acted decisively to save the euro by rescuing Ireland and agreeing the basis of a permanent debt resolution system, but financial markets were unconvinced.
The euro's respite rally was brief in the early hours of Monday's trading and European shares closed at a seven-week low, with banks among the losers as investor optimism over Ireland's debt bailout faded.
Yields on Irish government bonds were higher than Friday's close and off their lows seen in early trade after the agreement was sealed on Sunday. The spreads between Spanish and Italian bonds versus their German equivalent widened to euro-lifetime highs as optimism for the Irish deal waned.
Credit default swap costs on Portugal and Spain both hit record highs on Monday on fears they may be next in line to struggle with their debt.
"The benefits to Portugal and Ireland can be seen, but they're marginal. On the other hand, there is concern about the rest, with the spreads for Belgium, Italy and Spain all widening," Monument Securities strategist Marc Ostwald said.
"It just goes to reinforce the point that the market says 'when is the next problem going to occur?' And that is not going away," he added.
Under pressure to arrest the threat to the euro and prevent contagion engulfing Portugal and Spain, EU finance ministers on Sunday agreed an 85 billion-euro ($115 billion) package to help Dublin cover bad bank debts and bridge a huge budget deficit.
They also approved the outlines of a long-term European Stability Mechanism (ESM), based on a Franco-German proposal, that will create a permanent bailout facility and make the private sector gradually share the burden of any future default.
"ABSOLUTE DETERMINATION"
"This is a measure which is not simply a single shot taken in response to an important crisis, it forms part of the absolute determination of Europe -- of France and Germany -- to save the euro zone," French government spokesman Francois Baroin told Europe 1 radio.
German Finance Minister Wolfgang Schaeuble said calm and reality should return to financial markets and French Economy Christine Lagarde said "irrational," "sheep-like" markets were not pricing sovereign debt risk in Europe correctly.
Markets were unmoved by their urgings.
"I think it is almost impossible now to stop the contagion," said Mark Grant, managing director of corporate syndicate and structured debt products at Southwest Securities in Florida.
"PREVENTATIVE BAILOUT"
Portugal is widely seen as the next euro zone "domino" at risk and business confidence data for November added to the gloom. It fell for the second straight month on poor prospects for the economy due to austerity measures designed to calm investor concerns about its creditworthiness.
Portugal's Labour Minister Helena Andre said the government was preparing to start talks with firms and unions on reforming the labor market to increase competitiveness.
Nouriel Roubini, the U.S. economist who warned of an impending credit crisis before 2007, told the Diario Economico business daily that Portugal would likely need a bailout.
"Like it or not, Portugal is reaching the critical point. Perhaps it could be a good idea to ask for a bailout in a preventative fashion," he said.
Troubles in Portugal could spread quickly to Spain because of their close economic ties, and the Spanish government is seen as having to pay more to lure investors to Thursday's three-year bond offering.
Roubini said that while Spain had better budget and debt positions than other euro periphery states, high unemployment and the collapse of a property bubble meant that, like Ireland, its banking sector could need emergency aid.
"The question is whether it could happen in Spain. The official funds are not sufficient for also bailing out Spain," he said, and the fiscal cost of cleaning up its financial system would be bigger than government estimates.
NEW SAFETY NET
Under its bailout, Ireland was given an extra year, until 2015, to get its budget deficit down below the EU limit of 3 percent of gross domestic product, an acknowledgment that austerity measures will hit growth in the next four years.
Greece has been given a six-year extension to 2021 on loan repayments linked to its rescue, said Finance Minister George Papaconstantinou, at the price of a higher rate of interest.
The new European Stability Mechanism could make private bondholders share the cost of restructuring a euro zone country's debt issued after mid-2013 on a case-by-case basis.
Germany's Schaeuble, in comments aimed at calming markets, said it will take about five years from 2013 before a majority of outstanding euro zone bonds carry clauses to include private sector liability in future bailouts.
The lack of detail in an earlier Franco-German deal on a crisis mechanism, agreed last month, and talk of private investors having to take losses, or "haircuts," on the value of sovereign bonds, helped drive Ireland over the cliff.
Debt fears have driven the crisis for the past year, denting confidence in the 12-year-old euro currency and producing a showdown between European politicians and financial markets.
The proposed permanent crisis resolution mechanism, to be finalized in the coming weeks, is intended to prevent Europe having to rush like a fireman from one blaze to another.
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