LISBON/BRUSSELS (Reuters) - Portugal became the latest euro zone country to announce austerity measures to rein in a ballooning budget deficit yesterday as debt-stricken Greece urged global action to curb speculation in credit default swaps.

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 single currency zone.

German Chancellor Angela Merkel said she favoured the idea, which she said would require a change in the EU treaty, but the European Central Bank's chief economist branded it illegal.

EU sources said finance ministers of the 27-nation bloc would discuss ways to dampen speculation in the sovereign CDS 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 without owning the underlying Greek bonds, hence forcing up Athens' borrowing costs.

Greek Prime Minister George Papandreou, who took draconian austerity measures last week to stem attacks on his country's debt, called credit default swaps a "scourge" that threatened the Greek and global economy and asked the United States to join Europe in action on the issue.

"We need clear rules on shorts, naked shorts and credit default swaps. I hope there will be a positive response from this side of the Atlantic to bring this initiative to the G20," he told the Brookings Institution on a visit to Washington, where he will meet President Barack Obama yesterday.

Germany's financial regulator BaFin said it had found no evidence so far of massive speculation in Greek bonds since January, although demand for insurance of Greek debt had increased due to country risk. BaFin said it was keeping a close eye on euro zone sovereign debt and credit derivatives markets.

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

The programme 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 percent of GDP in 2012 and fall thereafter. Greece's debt is set to reach 125 percent of GDP this year.

"This is a bet on reducing the weight of the state in the economy and the weight of public spending," Portuguese Finance Minister Fernandio Teixeira dos Santos said.

Borrowing costs of the peripheral euro zone countries and the price of insuring their debt against default both fell after French President Nicolas Sarkozy gave the clearest indication so far that firm plans to help Greece 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 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.

Analysts said the Portuguese stability programme was more cautious than Greece's in its growth and revenue assumptions, but extra measures might still be required if growth fell short.

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. Spain's spread was down to 67 bps, the lowest since mid-January.

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."

Speaking to foreign journalists in Berlin, Merkel backed the idea of a European Monetary Fund and left open the possibility of emergency aid for Greece in future, while emphasising there was no need for it now.

"I think the idea (of an EMF) is a good one, " she said. "Without changing the (EU) treaty, it cannot be done. We would need a treaty change."

But ECB chief economist Juergen Stark, an old-school German deficit hawk, said the idea would breach the rules of European economic and monetary union and give perverse incentives to lax countries at the expense of states with solid finances.