Spain's borrowing costs shot up at a bond auction on Thursday, after economic data confirmed the country is back in recession and reports of an outflow of deposits from nationalized Bankia hammered its share price.
The Spanish Treasury had to pay around 5 per cent to attract buyers of three- and four-year bonds. The longer-dated paper sold with a yield of 5.106 per cent, way above the 3.374 per cent the last time it was auctioned.
"This ... fits the pattern of recent sales, with the Spanish treasury successfully getting its supply away but at ever-higher yields," said Richard McGuire, rate strategist at Rabobank in London.
"This unfavorable trend looks set to remain firmly in place ... Ultimately, this ratcheting up of yields will likely require some form of outside intervention," McGuire said.
Spanish Prime Minister Mariano Rajoy said on Wednesday his government, struggling to reduce its budget deficit, could soon find it difficult to fund itself affordably on the bond market unless the pressure eases.
His finance minister, Cristobal Montoro, meets heads of finance of all 17 regions later to review their budget plans which are a crucial plank of the drive to lower public debt.
The European Commission warned last week that stubbornly high debts in the regions and the welfare system would prevent Spain meeting its deficit goal of 5.3 per cent of GDP this year.
Spain's 10-year yields have spiked back above 6 per cent, which investors view as a pivot point that could accelerate a climb to 7 per cent, a cost of borrowing widely seen as unsustainable even though Madrid has sold well over half its debt needs for the year.
Top of the heavily indebted country's worry list is a banking sector beset by bad loans, the result of a property boom that bust in spectacular fashion.
El Mundo newspaper reported that customers at troubled Bankia SA had taken out more than 1 billion euros (NZ$2.2 billion,), equivalent to around 1 per cent of the lender's retail and corporate deposits, over the past week.
The government denied there had been an exit of funds, but the bank's shares dropped more than 20 per cent at one stage, extending the previous session's loss after it delayed publishing fourth-quarter results.
"It's not true that there is an exit of deposits at this moment from Bankia," said Economy Secretary Fernando Jimenez Latorre.
The government last week took over Bankia, the country's fourth-largest lender which holds around 10 per cent of Spanish deposits, in an attempt to dispel concerns over its ability to deal with losses related to the 2008 property crash.
"The majority of outflows came after the chairman resigned last week, but I think once the bank was taken over by the government, depositors calmed down a bit," said one Madrid-based trader. "The share price fall has to do with disappointed retail investors dumping the stock."
Spain's deposit guarantee fund guarantees 100,000 euros (NZ$166,206) per customer.
"I have two accounts with Bankia and up to now I have not closed them. I'm not even considering it," said Jose Ignacio Gonzalez, 42. "It must be more secure with the backing of the state, it has a guarantee."
The problem for Madrid is that property losses facing banks are not yet quantifiable, given prices are likely to fall further.
The government told the sector last week to set aside another 30 billion euros (NZ$50 billion) in provisions, prompting some analysts to say much more would need to be done.
A government spokeswoman said the bidding to select an external auditor to value real estate assets across the banking sector was still open, denying Oliver Wyman and BlackRock had been chosen as sources previously told Reuters.
RECESSION AND CONTAGION
While Greece, facing fresh elections which could hasten its exit from the euro zone, has dominated headlines, uncertainty over the final cost of Spain's banking reform has raised the prospect that it could require an expensive international bailout, a bill the euro zone would be stretched to cover.
Stuart Gulliver, head of Europe's biggest bank HSBC, reflected on his biggest external concerns.
"It's absolutely how the euro zone plays out and whether Greece stays in, and/or whether firewalls are high enough to protect Spain and frankly whether markets take things into their own hands before (Greek elections on) June 17," he said.
Official data confirmed the Spanish economy shrank by 0.3 per cent in the first quarter, putting it back into recession and facing a prolonged downturn as the government cuts spending in an attempt to wrestle down its budget deficit.
Unemployment is already running close to 25 per cent, rising to around 50 per cent among the young.
The government will publicize budget plans from 17 powerful autonomous regions later on Thursday, possibly rejecting some of them if they do not make deep enough spending cuts and giving local officials 10 to 15 days to redo them.
If the regional budgets are not approved by the end of the month, the central government can invoke a new law and take control of spending. The regions must cut 15 billion euros (NZ$25 billion) out of their budgets, after their overspending last year caused Spain to miss its deficit reduction target badly.
Even if it puts its house in order, Madrid faces the threat of contagion from Greece if it elects an anti-bailout government next month, a move which could hasten a hard default and exit from the euro zone.
"It's not Greece leaving the euro that is the major issue," said John Bearman, chief investment officer at Thomas Miller Investment, which manages roughly 3 billion pounds (NZ$5 billion) of assets. "It's the domino effect."