Greek exit fears hit bond markets

Madrid and Rome see borrowing costs rise as fears of Greek contagion are ratcheted up

Spain and Italy saw their borrowing costs spike again yesterday as investor fears intensified that those two nations could be knocked sideways by a sudden Greek exit from the single currency. Madrid had to pay an interest rate of 4.373 per cent to raise three-year money at an auction, up from 2.89 per cent in April. The interest rate on newly issued four-year bonds hit 5.106 per cent, up from the 3.374 per cent Madrid paid in March.

The interest rate on Spanish 10-year bond yields rose too in trading, ending at 6.3 per cent, a level regarded as unsustainable. Meanwhile, Italian 10-year borrowing costs rose above 6.06 per cent at one stage, before falling back to 5.97 per cent, as nerves about the ability of Europe's most indebted state to service its debts also increased.

Doubts about Spain's creditworthiness are growing because of the weakening domestic economy and rising uncertainty about the fate of Greece. "Spain is selling its debt at punitive rates against a rapidly deteriorating domestic and external backdrop," said Nicholas Spiro of Spiro Sovereign Strategy. "Eurozone 'break-up contagion' is seeping into Spanish yields."

If Greece crashes out of the single currency, imposing huge losses on creditors and bank depositors, many fear that investors will pull their money of other struggling eurozone states such as Spain and Italy, forcing those nations to seek a bailout from the European Union and the International Monetary Fund. The weak state of the Spanish economy was underlined by the Madrid-based national statistics authority yesterday, which confirmed that output shrank by 0.3 per cent in the first quarter of 2012, thus putting Spain in a double-dip recession. The Italian economy is also back in a slump, after contracting by 0.8 per cent in the first quarter of the year.

A senior Spanish civil servant yesterday called on the European Central Bank to offer more assistance to Spain since Madrid has delivered on its promised labour market reforms and has committed to €27bn (£22bn) in budget cuts this year. "We are doing everything necessary in terms of fiscal policy adjustments and structural reforms and we think there should be some type of reaction from the European Central Bank," said the Economy Minister, Jimenez Latorre. The ECB paused its bond-buying programme in February.

The largest purchasers of Spanish and Italian sovereign bonds in recent months have been the banks of those two countries. Italian banks are estimated to be holding €287bn in Italian sovereign bonds. Spanish banks are believed to have €220bn in Spanish state debt on their books. But analysts suspect that one of the reasons bond yields have been rising – along with rising fears about the safety of those loans – is that these banks are running out of the capacity to buy them.