Pressure continues to mount on Spain's Prime Minister, Mariano Rajoy, to request a bailout from the European Central Bank as the country strained to sell €4bn (£3.2bn) of debt.
Although the latest auction of Spanish two, three and five-year bonds was subscribed, the cost of borrowing rose again. The average cost of borrowing for three years rose from 3.83 per cent to 3.96 per cent.
Its two-year bond yields have also risen sharply in recent days. This is a result of Spain in effect playing a game of chicken with bond markets ever since the ECB last month unveiled a scheme to buy the bonds of eurozone members that requested it, provided tough conditions were met.
Michael Hewson, CMC Markets analyst, said: "People expect Spain to ask for a bailout, so they buy the bonds and push the yields on the debt lower. But the more they buy the bonds, the more Rajoy thinks Spain might be able to get away with it and is less likely to ask for a bailout."
The bailout plan is limited in its scope as it only covers short-term government debt on the secondary or resale market. Senior EU insiders are still worried that it may be necessary to buy Spanish government debt at source, from the primary market, particularly if borrowing costs continue to rise. However, this could soon drain the resources of the eurozone's rescue fund, the ESM.
Therefore, after a meeting between the Finnish Prime Minister, Jyrki Katainen, and the French President, François Hollande, the idea is to potentially offer investors in new Spanish government debt an EU-backed insurance policy that would pay out in case of default.
"We're talking of no more than €50 billion," said a senior source. "Under this scheme, the states would pose the conditions and make sure they're met, and the ECB would supply the firepower."
Christian Schulz, senior economist at Berenberg, commented that such an insurance scheme could shore up bond market confidence further: "With the ECB as a back-up, credit insurance could drive down Spanish borrowing costs further, particularly at the longer end of the maturity range." However, Mr Schulz added that the scheme "would be quite ineffective in a major market panic as investors would probably not be prepared to buy bonds even with partial credit insurance".
Confidence in Spain was also hit by its own central bank governor casting doubt on 2013 Budget deficit reduction plans. Luis Maria Linde said the government would have to consider further tax rises or cuts if it wanted to meet its budget targets.
"This outlook, a fall of 0.5 per cent in gross domestic product in 2013, is certainly optimistic in comparison with the outlook shared by the majority of international organisations and analysts, which is around a 1.5 per cent fall," Mr Linde told a Spanish parliamentary committee.
This is embarrassing for the Rajoy government as it only revealed its emergency budget last week. At the time, markets responded well to plans to cut the deficit by €40 billion. But if growth estimates prove wide of the mark, this will be difficult to achieve.
Meanwhile, following the announcement that Eurozone interest rates will stay on hold at 0.75 per cent, ECB chief Mario Draghi reiterated the bank's commitment to intervene as a "backstop" for struggling members including Spain, and that the euro is "irreversible". However, some analysts expect the poor state of the Eurozone economy to prompt a future rate cut.
Karen Ward, HSBC economist, said: "Activity is weak and likely to remain so in the near term and recover only gradually. Inflation risks are judged to be broadly balanced and a rate cut wasn't considered. We still think a further cut of 0.25 per cent is likely in the coming months."Reuse content