Spain thrown lifeline by Brussels with extra year to cut deficit

Relief for Madrid as fears over banks see country's borrowing costs at their highest since it joined euro

Beleaguered Spain was handed a lifeline by the European Commission yesterday as the nation was given an extra year to slash its deficit.

The relief for Spain – in the grip of a double-dip recession and record unemployment of 5.64 million – came as fears over its struggling banks pushed Madrid's borrowing costs up to 6.67 per cent, the highest since the country joined the euro.

The latest panic sent investors running for cover across Europe as Italy took a fresh hammering in bond markets, and the euro plunged to a new, two-year low of $1.2407 against the dollar.

Under the terms of the fiscal pact, Spain is obliged to cut its deficit to 3 per cent in 2013, forcing a brutal €27bn (£21.5bn) in budget cuts from Prime Minister Mariano Rajoy's centre-right administration. But these targets are widely seen as optimistic given Spain's economic woes. The commission's economic and monetary affairs commissioner, Olli Rehn, said Spain would be given an extra year to meet the target, subject to controls on spending.

Mr Rehn said: "We are ready to consider proposing an extension of the deadline to correct the excessive deficit."

The relaxation of deficit targets came amid fresh concerns over Spain's banks as the European Central Bank insisted that it was up to individual nations to strengthen bank balance sheets.

"The funds needed to ensure banks' compliance with capital requirements, cannot be provided by the eurosystem," the ECB said.

The rare intervention from the ECB scotched reports that Spain was planning to recapitalise its fourth-biggest bank, Bankia, with government bonds which could be swapped for central bank cash.

Spain now has to throw itself on the mercy of the debt markets to prop up its ailing banking system. Many of its regions, including wealthy Catalonia, are adding to the pressure and demanding a central government bailout to refinance their debts.

Spain's banks – laden with €184bn in struggling property loans – have taken centre-stage in the crisis, although the threat of a Greek pullout of the euro is still hanging over the markets ahead of elections on 17 June.

The commission's latest assessment of Spain warned that its worsening economy could "require further strengthening of the capital buffers of banks", and warned that other vulnerabilities in the system – such as exposures on loans to small business and residential mortgages – "have not been addressed".

Spain's stock market crashed 1.9 per cent to nine-year lows in a torrid day for European shares which saw France's Cac 40 and the FTSE 100 slide 1.7 per cent, and Germany's Dax fall 1.4 per cent. London's blue-chip benchmark is now on course for its worst month since last August when the latest dangerous phase of the debt crisis erupted.

Italy was forced to pay 6.03 per cent to borrow for 10 years as it raised €5.7bn from turbulent bond markets, the highest rate of interest since its January auction. Investors instead flooded cash into safe-haven assets as Germany's cost of borrowing sank to an all-time low and yields on US Treasuries – the world's ultimate, risk-free asset – skirted with 60-year lows seen in September.