Portugal's government bond yields hit new highs this morning after its parliament rejected new austerity measures and its prime minister Jose Socrates resigned.

The country's borrowing costs are now seen as unsustainable, with the interest rate demanded by investors to lend it money for 10 years rising above 7.9%. The yield on five-year Portuguese bonds hit 8.5%.

Portugal faces €4.8 billion of bond repayments in April followed by €6.95 billion in June. This increases expectations that Portugal will need an EU/IMF bail-out soon.

The Portuguese crisis comes as the leaders of the EU's 27 member states gathered in Brussels today.

Speaking before the summit, the head of the European Commission José Manuel Barroso said budget cuts voted down by parliament in Lisbon were 'indispensable'.

'It is important for confidence in the Portuguese economy that the consensus that I believe exists in Portugal regarding the need to achieve fiscal consolidation (and) structural reforms is clearly reaffirmed,' he said.

Rocked by the Socrates resignation, EU leaders are staring at the imminent prospect of a third emergency financial bail-out since May last year if Portugal cannot take the required action.

But a Portuguese cabinet spokesman said the country's outgoing government would 'continue to do all it can' to avoid a bail-out.

Mr Barroso said that targets including a Portuguese commitment to reduce its annual deficit to 4.6% of GDP this year, backed by euro zone leaders at a special summit earlier this month, 'are indeed indispensable for confidence in the European economy'.

The two-day summit was supposed to focus on strengthening economic governance, but many issues have been postponed, including a decision on reducing the interest rate on Ireland's EU-IMF bail-out.

It appears that the question of Ireland's interest rate is off the table until stress tests on its banks have been completed.

Meanwhile, credit rating agency Moody's has downgraded the credit ratings of 30 Spanish banks, warning that Spain's government may not be ready to write a blank cheque for every troubled bank.

Kenny, Van Rompuy in call over rate

Taoiseach Enda Kenny has said the decision not to seek to conclude a deal on Ireland's EU/IMF deal interest rate at the two day summit in Brussels was reached after a phone call with the President of the European Council Herman Van Rompuy yesterday.

Speaking to reporters as he arrived at the summit, Mr Kenny said it was better to know the full extent of the liabilities facing the Irish banking sector before continuing with negotiations.

He rejected what he called ‘extreme figures’ being 'bandied about' regarding the scale of the recapitalisation needs in the sector without specifying what they were.