Pain piled on Spain as interest rates shoot up

Bond yields touch 6 per cent and central bank chief warns on capital levels

Spanish borrowing costs rocketed yesterday as investor fears about the nation's public finances came roaring back and the head of the central bank warned that the country's ailing banking sector might require further official support.

The yield on 10-year Spanish sovereign debt breached 6 per cent at one point in trading yesterday, the highest level since the beginning of the year, as markets signalled concern that Madrid could be forced to follow Greece, Ireland and Portugal and seek a bailout from the European Union and the International Monetary Fund. The cost of insuring Spanish debt also increased, with five-year Credit Default Swap rates widening to 4.78 per cent.

On Monday, the Spanish prime minister, Mariano Rajoy, announced a further €10bn (£8.25bn) of spending cuts, on top of the €27bn package of austerity measures and tax rises for 2012 his government unveiled earlier this month. But some analysts fear the large cuts in spending will undermine demand and push the Spanish economy, which is already forecast to contract by 1.7 per cent over 2012, still deeper into recession and make it impossible for the country to service its debts.

Market alarm over Spain's fiscal position was exacerbated yesterday by a warning from central bank governor Miguel Angel Fernandez Ordonez that prolonged recession would undermine the solvency of Spain's banks, forcing them to seek more capital from the Spanish government.

"If the economy worsens more than expected, it will be necessary to continue increasing and improving capital as necessary in order to have solid entities," he said.

There was further discouraging news for Spain yesterday in a new International Monetary Fund (IMF) study showing that recessions which follow large increases in household debt levels tend to be especially severe. Spain – along with the Iceland, Ireland and the UK – experienced a significant asset price boom in the years leading up to the 2008 financial crisis. Some analysts have suggested there remains a €100bn hole in the Spanish banking sector due to bad property loans, despite moves last year to recapitalise some of its weaker financial institutions.

The IMF study also suggested that the international boom in commodity prices could be set to plateau or fall.

"Given weak global activity and heightened downside risks to the near-term outlook, commodity exporters may be in for a downturn," the study said.

Despite the recent jump in Spanish borrowing costs, the European Commission yesterday voiced its support for the package of cuts announced by Madrid.

"We have seen the new measures and the commission welcomes those favourably," spokesman Olivier Bailly, told reporters.

Mr Rajoy is due to outline where the spending cuts will fall today. The Spanish government is believed to be looking for savings from the health and education budgets.

Madrid has been set a target by the European Commission of reducing the country's budget deficit from 8.5 per cent to 5.8 per cent by the end of 2012, and to 3 per cent in 2013.