The European Commission said it was prepared to propose the creation of an IMF-style European Monetary Fund to cope with future debt crises in the euro zone.

EU sources said EU finance ministers would discuss ways to dampen speculation in the sovereign credit default swaps market at their next meeting on March 16. Hedge funds have been accused of aggravating the Greek debt crisis by so-called “naked short selling” -- betting on a default on the CDS market without owning Greek bonds, hence forcing up Athens' borrowing costs.

Portugal unveiled plans to cut its deficit to 2.8% of gross domestic product in 2013 from 8.3% this year by trimming spending on civil servants and public investment, and raising taxes on high incomes and stock market gains.

The program is seen as the key to convincing markets that Portugal will tackle its high deficit and debt after coming under scrutiny by investors fearing it may be next in line to have Greek-style fiscal problems.

Under the plan, Portugal's public debt would peak at 90.1% of GDP in 2012 and fall thereafter. Greece's debt is set to reach 125% of GDP this year.

Greece's borrowing costs and the price of insuring Greek debt against default both fell after French President Nicolas Sarkozy gave the clearest indication so far that firm plans to help Athens were ready if needed.

The premium investors charge to hold Greek debt rather than German benchmark bonds has risen as high as 400 basis points this year, prompting Athens to announce its third and most draconian package of public sector pay cuts, a pensions freeze and sales tax rises last week.

The Greek bond spread fell to 283 bps after Sarkozy told Prime Minister George Papandreou on Sunday that the euro zone would stand by Greece. French Finance Minister Christine Lagarde was working with euro zone colleagues “on a certain number of precise measures if Greece needs them,” he said.

Portugal's spread over benchmark 10-year German bunds stood at 109 basis points on Monday, down from a peak of 175 bps on February 4 at the height of the market panic over Greece.

European Economic and Monetary Affairs Commissioner Olli Rehn said in a newspaper interview that Paris, Berlin and Brussels were working on an EU instrument that could help euro zone states in trouble on “strong conditions.”

German Finance Minister Wolfgang Schaeuble, in charge of Europe's biggest economy, endorsed the idea of a European Monetary Fund in a weekend newspaper interview.

Rehn's spokesman told a news briefing the EU executive was ready to propose setting up a rescue fund for the euro zone, drawing on the lessons from the Greek crisis.

“The Commission is ready to propose such a European instrument for assistance which will require the support of all euro area member states,” spokesman Amadeu Altafaj Tardio told a briefing in Brussels.

However, he stressed that details of the idea, including whether it would require an amendment to the EU treaty, had yet to be pinned down, and the instrument would not be ready in time to be relevant to the current crisis.

The head of the International Monetary Fund told Reuters earlier that the euro zone was capable of dealing with Greece's problem without his institution's intervention.

IMF Managing Director Dominique Strauss-Kahn told Reuters that Greece's financial problems were unlikely to spread to other euro zone countries with high levels of public debt.

“We have a problem with Greece. We don't have a problem with Spain to date. The euro zone has to deal with the Greek problem. They are doing this. No one knows what's going to happen tomorrow morning, but there's no reason why the spillover to Portugal or to Spain will take place,” he said in an interview in Nairobi. (Reuters)