Berlin/Santander, Spain: Spain said on Monday foreign banks were refusing to lend to some of its banks in a new twist to the euro zone crisis, and Germany said an EU aid mechanism was in place if Madrid needed a Greek-style rescue.

Highlighting persistent doubts about Greece’s ability to repay its debt mountain despite last month’s €110 billion multilateral bailout, credit ratings agency Moody’s downgraded Greek sovereign debt by four notches to junk status.

In a statement explaining the unusually steep cut, Moody’s cited the “macroeconomic and implementation risks" in Athens’ draconian austerity programme, agreed with its 15 euro zone partners and the International Monetary Fund.

Spanish Treasury secretary Carlos Ocana admitted officially for the first time that some Spanish banks faced a liquidity freeze in the interbank market and said the government was working to restore confidence.

“It’s definitely a problem," Ocana told a conference of business leaders at a conference in the northern town of Santander when asked about the credit squeeze. But he said Madrid was not negotiating any financial aid package.

“Spain does not need additional financing from any international institution. The rumour is false and I deny it."

In Berlin, German Chancellor Angela Merkel was asked after talks with French President Nicolas Sarkozy about media reports that Madrid could seek aid from a new €750 billion European Financial Stability Facility as early as this week.

“If there should be problems — and we shouldn’t talk them up — the mechanism can be activated at any time," Merkel said. “Spain and any other country knows that they can make use of this mechanism if necessary."

The fourth largest economy in the euro area, Spain needs to refinance €16.2 billion of bonds in July. It has been able to borrow on the markets but at a rising premium, paying an average 3.317% to sell three-year bonds last Thursday.

Banking sources said last week the liquidity freeze was affecting savings banks and small banks but not the country’s biggest financial institutions.

Rescue Talks Denied

The German Finance Ministry and the European Commission denied a report in the Frankfurter Allgemeine Zeitung that EU states would hold talks on aiding Spain in Brussels this week.

Spanish banks have been under pressure since the Bank of Spain stepped in last month to take over CajaSur, a small, 146-year-old lender controlled by the Catholic Church, highlighting the precarious position of other savings banks.

The chairman of Spain’s second-largest bank BBVA said the country’s top task was to restore market confidence through a mixture of deficit cutting, structural reforms and recapitalising and slimming down its financial sector.

“We need a solvent and stable financial system, a substantial reduction in the installed capacity in the sector and a sufficient injection of funds," BBVA’s Francisco Gonzalez told the same conference, adding that Spanish banking faced a “difficult and uncertain future".

The euro and European stocks rose by more than 1% at the start of a decisive week for reforms in Europe aimed at preventing a repeat of Greece’s debt crisis. But the euro fell back slightly after the Moody’s downgrade.

Merkel and Sarkozy said the two biggest euro zone economies had agreed on stricter budget rules for the single currency area, three days before an EU summit, including suspending the voting rights of a country in persistent breach.

EU finance ministers have drafted new rules designed to enforce the bloc’s budget deficit limit of 3% of national output by applying earlier and tougher sanctions to countries in breach, and extending greater discipline to public debt.

Both leaders said they were determined to strengthen fiscal discipline within the bounds of the EU’s Lisbon treaty. Sarkozy said lawyers would have to determine whether a treaty amendment was necessary to suspend a country’s voting rights.

They also said they had agreed that Europe needed a stronger “economic government" to coordinate national economic policies, but, in a clear victory for Merkel, this would comprise the leaders of all 27 EU states, not just the 16 euro zone members.

Sarkozy said they had also agreed that euro zone heads of state and government could meet “pragmatically and flexibly" when problems arose that specifically affected the single currency area. France had sought an “economic government" centred on the euro zone with its own permanent secretariat.

Finance ministers of the Group of Seven nations — the United States, Japan, Germany, Britain, France, Italy and Canada — conferred by telephone on Monday to prepare for a G20 leaders’ summit later this month, but several officials said they did not discuss Spain’s fiscal problems.

Merkel and Sarkozy said they were sending a joint letter to Canadian Prime Minister Stephen Harper, the G20 chairman, seeking more ambitious reforms in financial regulation, a global tax on financial transactions and agreement in principle on a levy on banks to pay for the cost of financial crises.

Structural Reforms

In the latest of a wave of structural reforms designed to adapt strained public finances to long-term challenges and make euro zone economies more competitive, France is set to announce an overhaul of its pension system and Spain a shake-up of its labour market, both on Wednesday.

European governments are taking advantage of the sense of urgency instilled by last month’s $1 trillion financial backstop for the euro zone and, critics say, of voters’ distraction by the soccer World Cup, to push through unpopular measures.

European Central Bank Governing Council member Patrick Honohan, trumpeting a concerted message from the ECB, said the market response to perceived euro zone fiscal risks had been overblown.

“This (nervousness) led to the situation a few weeks ago where you had effectively frozen money markets, interbank and the like, reflecting what seems to be an overblown response to perceived fiscal risks," the Irish Central Bank chief told a conference in Dublin.