Credit-default swaps tied to Greek debt jumped 18 basis points to 250 after S&P lowered its long-term grade one step to A-, according to CMA Datavision prices At 2:45 p.m. in London. Contracts on governments throughout Europe rose.

"The ongoing global financial and economic crisis has, in our opinion, exacerbated an underlying loss of competitiveness in the Greek economy,” S&P analyst Marko Mrsnik said in a statement today.

The euro-region's economy is faltering after the European Central Bank failed to lower interest rates as fast as the U.S. and U.K. The shadow ECB council, a group of economists that monitors the Frankfurt-based central bank, said yesterday it expects Europe's economy to shrink 1.8 percent this year. That compares with a contraction of 1 percent in the U.S., according to a survey by Bloomberg News.

Credit-default swaps on Greece have soared 168 basis points since September, while Ireland climbed more than seven-fold to 217, Spain rose about 72 basis points to 123.5 and Portugal increased 81 to 121. Contracts linked to the debt of lower-rated Mexico and Vietnam fell in the same period.

"The peripheral countries are coming under pressure,” said Ian Stannard, a currency strategist at BNP Paribas SA in London. “Given the huge supply of bonds that's due, this is going to make things more tricky. It's going to leave the euro extremely vulnerable.”

Borrowing Costs

The 16-nation common currency was trading at $1.3118 today, down from last year's high of $1.6038 on July 15. The ECB meets tomorrow to decide borrowing costs and will likely cut its target rate to 2 percent from 2.5 percent, according to the median estimate of 60 economists surveyed by Bloomberg.

Merrill Lynch & Co.'s European Union Government Bond Index is down 0.58 percent this year after rising 9.83 percent last year. The firm's index of German bonds gained 12.2 percent, while one tracking Spanish debt increased 8.78 percent. The index tracking U.S. Treasuries surged 14 percent.

Greece was put on watch for a possible cut by S&P on Jan. 9 as sliding support for the government hampers the country's ability to ride out the economic crisis. The same day, the ratings firm lowered the outlook for Ireland's debt to “negative” from “stable.”

Portugal yesterday became the third euro nation in a week to be threatened with a debt downgrade when S&P's said the country's long-term rating may be lowered from AA-. Spain faces “significant challenges” and may have its top AAA rating lowered, the ratings firm said Jan. 12.

Difficult Challenges

"In our opinion, Portugal faces increasingly difficult challenges as it tries to boost competitiveness and persistently low growth against the backdrop of a heavy debt burden and very high imbalances,” S&P said in a statement. Government attempts at reform “have proven insufficient,” it said.

Portugal's government forecast that it will record a budget deficit of 3 percent of gross domestic product in 2009, the edge of the European Union's limit under the Stability and Growth Pact. The economy will contract this year for the first time since 2003 as its main export markets weaken and Portuguese consumers rein in spending, the central bank forecast Jan. 6.

Rising Swaps

Credit-default swaps on Portugal rose 13.5 basis points to 121 basis points after S&P's move, up from about 40 basis points in September. A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a country or company fail to adhere to its debt agreements. An increase signals deterioration in the perception of credit quality; a decrease, the opposite.

There is an “increasing disparity and deterioration in the quality of European sovereigns,” Emma Lawson, a currency strategist in London at Merrill Lynch, wrote in a report yesterday.

Five-year credit-default swaps on Mexico have fallen 81 basis points to 309 since Oct. 13, CMA data show. Contracts on Vietnam have dropped 22 basis points to 436 basis points.

Ireland has the highest credit-default swaps for a AAA rated nation in the European Union at 217 basis points, CMA data show. Italy is the highest of the AA's, trading at 167.5, and Estonia, rated A by S&P, is at 523.

Bond Yields

Yields on the bonds of smaller European economies, such as Spain, Italy and Greece, have risen to the highest relative to German bunds since before the ECB was established a decade ago. Spanish 10-year notes yield 99 basis points more than bunds, up from 17 basis points one year ago. For Italian notes, the gap almost quadrupled to 141 basis points from 36 basis points.

"Much of the rationale behind these moves has been focused on the risk of a breakup in the euro or a specific country being ejected from the union,” Charles Diebel, the head of European interest-rate strategy at Nomura International Plc, wrote in a note to clients. “This makes little sense and is not a valid risk scenario at this point in time.”

Budget deficits are rising across the euro region as Europe faces a recession that may be the worst since World War II. The economy will shrink 1.8 percent in 2009, twice as much as in 1993 and four times what the ECB forecast last month, Royal Bank of Scotland Group Plc economist Jacques Cailloux in London wrote in a report to clients yesterday.

Rate Cuts

The slump is putting the ECB under pressure to cut its key interest rate again this week even after it reduced it by 1.75 percentage point since early October. The Federal Reserve has already cut its target rate for overnight loans between banks to as low as zero.

"The ECB is behind the curve in its rates policies and the sooner this can be corrected, the better,” Erik Nielsen, chief European economist at Goldman Sachs Group Inc. in London and part of the shadow ECB, said in an e-mailed report yesterday.

Spanish Finance Minister Pedro Solbes said Jan. 13 that the country's budget deficit will “substantially” exceed the European Union's limit of 3 percent of GDP this year.

Europe's downturn may take the biggest toll on countries already saddled by debt. Italy's burden rose to 109 percent of gross domestic product in October, the highest in the euro region, and the International Monetary Fund in Washington estimates that will limit Prime Minister Silvio Berlusconi's ability to revive the economy.