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LONDON/ATHENS (Reuters) - Cautious optimism that the euro zone crisis may be turning a corner fuelled demand for European government debt on Wednesday, easing pressure on Portugal, seen as the most vulnerable country after Greece.
Portuguese bonds led a rally in debt issued by the euro zone's lower-rated states, capitalizing on a successful treasury bill auction and on increased confidence a deal to reduce Greece's debts to private bondholders will be clinched this week.
Ambitious economic reform programs announced by the new governments of Italy and Spain have helped improve market sentiment around the euro's future, although there are concerns that a deep recession in southern Europe may yet derail debt reduction efforts.
Meanwhile, there was fresh evidence that the European Central Bank's flooding of European banks with cheap, three-year money is easing lending among banks and improving investors' willingness to take risk.
Portugal, which many analysts believe will need a second EU/IMF bailout after Greece, proved its ability to tap short-term debt markets when it sold 1.5 billion euros of three- and six-month bills at lower yields. That helped bring down the market yield on its 10-year bonds from a record 17.4 percent on Tuesday to a still high 15.8 percent.
In Greece, Prime Minister Lucas Papademos sought backing from political leaders for more austerity measures, with the International Monetary Fund warning that long-term, cross-party commitment to reforms is key to securing a new bailout.
With a long-delayed agreement with private sector creditors to cut the country's debt by 100 billion euros nearly wrapped up, the EU, the IMF and Greece are racing to complete talks on a 130-billion-euro bailout by the end of this week.
"We need an agreement with political leaders for the negotiations with the troika," said a government official who declined to be named.
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The IMF's chief negotiator with Athens, Poul Thomsen, stressed that international lenders needed to be confident that whoever wins elections penciled in for April accepts the key objectives of a new Greek adjustment program.
"We need assurances that whoever is in power after the election and reasonably wishes to make some changes in economic policy will make sure they are in line with the targets and the basic framework of the agreement," he told daily Kathimerini.
But Thomsen also called for a new policy mix, which could help get political parties on board.
"We will have to slow down a little as far as fiscal adjustment is concerned and move faster - much faster - with implementing reforms," he said, adding that there are limits to the pain that Greek society can take.
The deal is aimed at reducing Greece's debt to 120 percent of gross domestic product in 2020 from around 180 percent now, but it hinges on Athens meeting fiscal targets and reform benchmarks which is has repeatedly missed so far.
The debt-reduction deal will require some contribution from public sector bondholders to plug an estimated 15 billion euro funding gap, raising pressure on the ECB and euro area national central banks to forego profits on Greek bonds they bought in the market at a discount.
The ECB has refused to say how it might help.
"Even in small settings they keep their cards close to their chests," said one official involved in the talks.
ECB sources told Reuters last week that the central bank had paid 38 billion euros to buy Greek bonds with a face value of 50 billion as part of its bond-buying program to prop up Athens.
That leaves the central bank sitting on a nominal gain of 12 billion euros that could be channeled back to Athens to help reduce its debt-to-GDP ratio without losses being incurred.
An EU official said that would still not be enough to close the full funding gap estimated at nearly 10 percentage points to get Greek debts down to 120 percent of GDP.
To achieve that, the ECB or national central banks may have to take losses on their holdings or forego interest payments. Some national central bank balance sheets couldn't handle such losses and would have to be recapitalized, the sources said.
In the money markets, the effects of the ECB's long-term liquidity glut for banks continue to lower stress levels, with a second installment of cheap money due later this month.
European interbank lending rates fell to near an 11-month low on Wednesday and euro zone banks' demand for ECB dollar funding fell to the lowest level since the cash injection.
An ECB report said a quarter of euro zone banks had tightened conditions in late 2011 for firms to get loans this year, but analysts said the central bank's massive cash injection meant that survey was already out of date.
"It is all a bit after the horse has bolted. Looking forward one might expect the situation has already improved," Societe Generale economist James Nixon said.
Additional reporting by Luke Baker in Brussels, Angeliki Koutantou in Athens, Ana Nicolaci da Costa in London; Writing by Paul Taylor; editing by Janet McBride