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German Chancellor Angela Merkel signaled to lawmakers in a closed-door meeting that she was prepared to agree an increase in Europe's rescue fund later this month, participants said, but only under conditions that other states may find difficult to accept.

Investors pushed the single currency to a one-week low under $1.38, the risk premium on Spanish bonds widened and the cost of insuring Spanish, Greek and Portuguese debt against default rose as a fresh wave of euro zone jitters hit financial markets.

Leaders from the currency area are expected to back a watered-down version of a German-French plan to boost economic competitiveness at Friday's Brussels summit but are unlikely to overcome sharp differences over whether the rescue fund should be given new powers that would help it ease the burden on highly-indebted euro states.

A German official lowered any expectation of a breakthrough, saying no decisions would be taken on strengthening the European Financial Stability Facility (EFSF) on Friday.

The question of raising the fund's lending capacity would be decided in a package at the end of March, he said, and Berlin opposed giving the EFSF or its successor any direct or indirect role in buying troubled states' bonds on the secondary market.

Merkel told members of the Bundestag's European affairs committee, according to the participants, that boosting the fund would depend on countries that do not have a triple-A rating injecting capital, a step some of them have already signaled they will resist.

EU diplomats said France and several other countries want at least an outline agreement on Friday on the remit of a planned permanent financial rescue mechanism for the euro zone.

"The quicker we get a deal the quicker we calm the markets," one senior diplomat said.

Traders said the euro could fall further due to market concerns that Friday's 17-nation meeting and a summit of the full 27-nation European Union on March 24-25 may fail to agree on decisive action to tackle the debt crisis.

"If officials make no progress and Germans remain unwavering in their demands, the likelihood of a capitulation (in the euro) will be significantly higher," said Jessica Hoversen, currency strategist at MF Global in Chicago.

SPAIN, PORTUGAL UNDER PRESSURE

Moody's Investors Service cut Spain's sovereign debt rating one notch to Aa2 and warned of further downgrades, estimating the capital shortfall at the country's banks at 40-50 billion euros, or as much as 110-120 billion euros under a more severe stress scenario.

That clashed starkly with a new 15 billion euro shortfall estimate from the Bank of Spain, which raised questions about the credibility of official forecasts.

"(Moody's) believes there is a meaningful risk that the eventual cost of the recapitalisation effort could considerably exceed the government's current projections," the credit ratings agency said in statement.