Just as European ministers approved a rescue of Spain's troubled banks, the region of Valencia revealed it would become the first to tap a new, week-old fund designed to provide liquidity to the country's 17 semi-autonomous regions.
The yield on Spanish 10-year bonds shot up 0.25 percentage points to 7.22 per cent on the news, while the Ibex stock index fell 4.5 per cent.
Many Spanish regions are so heavily in debt — due to the recession and a burst real estate bubble — that they cannot raise money at affordable rates. As a result, they are struggling to repay creditors and settle contract bills. Like the central government, many have enacted stinging austerity measures with cuts in health care and other services.
Valencia's Vice-President Jose Ciscar declined to say how much the eastern coastal region is asking for. He and Treasury Minister Cristobal Montoro refused to call it a bailout, however.
"Just as other regions are, Valencia is suffering from the consequences of liquidity restrictions in the markets as a result of the current economic crisis," Ciscar told reporters.
Investors fear the central government, which is also strapped for cash and faces high borrowing rates on bond markets, could come under increasing financial pressure if the regions need more help. That adds to existing worries about saving the ailing banks, which the central government will rescue with up to €100 billion in eurozone loans.
These troubles have intensified fears that Spain will be the next eurozone country after Greece, Ireland and Portugal to need a sovereign bailout. The problem is Spain's economy is bigger than those three combined and financing its debt could prove too expensive for the rest of the eurozone.
The aid request by the region of Valencia, if approved, would come at a cost: it will have to abide by strict budgetary conditions set by the central government.
For many in Spain, Valencia is a symbol of all that went wrong in the boom years: rampant spending to build row after row of beachside condos that are now empty, or repossessed by banks and being sold at fire-sale prices.
The fund for the regions was created only last Friday and will have €18 billion ($22 billion) in capital. A third of that is a loan from the state-owned company that runs Spain's many lotteries.
Meanwhile, the central government on Friday approved parts of a €65 billion austerity package that includes VAT tax hikes and cuts in pay for civil servants. They already saw their wages reduced in 2010 as Spain first started dealing with its deficit woes. Hundreds of thousands of people demonstrated Thursday night in the streets of Madrid and dozens of other cities to protest against the austerity package.
Montoro forecast Spain's recession will drag on into 2013, although the economy will not be quite as weak as it now.
The economy will contract 0.5 per cent in 2013, compared with the previous forecast for it to grow by 0.2 per cent. Unemployment, which is now at 24.4 per cent, will remain about the same next year, he said.
This year the economy will shrink 1.5 per cent, a slight improvement from the 1.7 per cent drop predicted until now, he said.
Montoro gave the new forecasts to reporters shortly before the eurozone approved the terms of a bailout of up €100 billion for Spanish banks, laden with mountains of soured real estate investments following the bursting of a property bubble.
Mark Miller of Capital Economics in London said the forecast that recession will extend into next year spooked investors.
"A prediction that there will be no growth until 2014 is the last thing the markets wanted to hear right now," as it weakens Spain's ability to lower its deficits.
Miller said it was increasingly likely that Spain would need a sovereign bailout, even though its overall public debt low is low compared with many other European countries.
"With financing costs up at around 7.25 for the 10-year there is no doubt that debt servicing is very much a problem in Spain and may become enough of a problem to force a sovereign bailout."
Harold Heckle contributed to this report.Suggest a correction