Investors pushed the country's borrowing rates to alarming heights Monday amid concern the government could be overwhelmed by debt and forced to seek an international bailout.
The interest rate, or yield, on Spain's 10-year bond spiked 0.22 percentage points to 7.45 per cent. That is the highest level since the euro began in 1999 and is considered unsustainable for more than a few months. The main stock index tanked as much as 5 per cent before recovering somewhat.
Concern over Spain increased after the central bank said Monday that the economy contracted by 0.4 per cent during the second quarter. The government predicts the economy will keep contracting into 2013 as new austerity measures — such as tax hikes and benefit cuts — hurt consumers and businesses.
The gloomy outlook has increased worries about public finances because shrinking economic output deprives the government of revenue it needs to lower the deficit. The government has earlier this year conceded it will not meet its target to reduce the 2012 deficit to 5.3 per cent of GDP, aiming instead for 6.3 per cent.
Investors also worry the government will face new costs to help its ailing banks and regions. Spain has asked for a eurozone bailout package of up to €100 billion ($121 billion) to save the banks, but is ultimately liable to repay the money if the banks do not.
The eastern region of Valencia revealed Friday it would need a bailout from the central Madrid government. Over the weekend, the southern region of Murcia said it may also need help. Speculation is now strong that several other cash-strapped regional governments may follow.
A fund for Spain's 17 regions was created on July 13 and will have €18 billion ($22 billion) in capital. Many regions are so heavily in debt due to the recession and the burst real estate bubble that they cannot raise money on their own.
The problem is the central government is facing high borrowing costs, too.
If those borrowing rates do not fall back, the central government may end up being locked out of international markets and be forced to seek a financial rescue, like Greece, Ireland and Portugal.
"The higher the yield goes, the more untenable the situation becomes," said Rebecca O'Keeffe, head of investment at Interactive Investment.
Spain is the fourth-largest economy in the eurozone, bigger than Greece, Ireland and Portugal combined. Its €1 trillion economy would prove too expensive for the continent's €500 billion bailout fund, a third of which is already tied up in the other three bailouts.
A debt default by Spain would rock global financial markets and threaten the existence of the euro currency. That's why finding a way to lower its borrowing rates is crucial for the financial wellbeing of Europe and the global economy.
Spain has called for the European Central Bank to take emergency action to ease its government borrowing rates. In the past, the ECB has bought bonds on the open market, lowering their yields, or interest rates. It has also given banks €1 trillion in cheap loans to ensure they have enough cash to lend to the economy.
But these measures have over the past two years only temporarily lowered government borrowing rates. The ECB claims the measures are not effective in fighting the crisis and that governments need to take action by, among other things, sharing countries' debt loads.
Spain has already issued €59 billion of the total €86 billion in debt it plans to sell this year, meaning it is not under heavy pressure to hold auctions. The Treasury, however, will test market sentiment with a sale of three- and six months bills on Tuesday.
In stock markets, Spain's benchmark Ibex 35 index was down more than 2 per cent by early afternoon after plunging 5.8 per cent on Friday.
The losses had been heavier early Monday, before Spain's market regulator placed a three-month ban on short-selling of shares. In a short sale, investors sell stock they do not own, betting they can buy it back at a lower price.
The latest bout of jitters comes barely a month after the leaders of the 17-country eurozone agreed a package of measures designed to instil confidence in the markets. Those measures included the rescue loans for Spain's banks.
The banks carry massive amounts of soured real estate investments following the collapse of the country's property bubble in 2008. Many of the most vulnerable banks — the savings banks, or cajas — have been forced to merge to avoid collapse.
Economy Minister Luis de Guindos insisted Monday that Spain would not need a sovereign bailout and said the intense market pressure was due to uncertainty over the future of the single euro currency.
"There are situations of irrationality in the short term behaviour of the markets, extreme nervousness which can't be resolved by governments and must be sorted out from other angles," he told reporters before going into Parliament to discuss the rescue package for the banks.
"Spain right now is the breakwater in the current uncertainty surrounding the euro. But this goes beyond Spain," he said, adding the country had done its part by approving several economic reforms.
De Guindos said Spain will pay between 1.5 per cent and 3 per cent in interest for the banks' bailout loans. The full amount of the loans needed will not be known until September, after individual banks' finances have been studied.
The Spanish government has pushed through another round of austerity and structural reforms to convince investors of its creditworthiness. However, opposition to the government's strategy is increasing, especially as the country is mired in its second recession in three years and weighed down by an unemployment rate of nearly 25 per cent.