Spain will soon issue new bonds to fund its ailing banks and indebted regions despite borrowing costs nearing the unsustainable 7 percent level that forced other eurozone countries to seek international aid.
The move will further worsen public finances which are under scrutiny from investors and European officials concerned that Spain will fall victim to the regional debt crisis that led to bailouts in Greece, Portugal and Ireland.
Spain's banks and regions are at the heart of its economic problems and economists say there is little hope of emerging from recession until they have been reinforced.
A government source told Reuters on Tuesday Spain would likely recapitalize Bankia, which asked for 19 billion euros on Friday, by issuing new debt and possibly by tapping the cash from the bank restructuring fund and the Treasury.
"There is a clear preference to tap the market. The other option (injecting state bonds directly into Bankia) is marginal," the government source said.
"The (bank restructuring fund) FROB has liquidity and can tap the market. The Treasury also has a strong liquidity position. We'll choose one or the other mechanism."
It has become increasingly expensive for Spain to issue debt. The risk premium demanded by investors to hold 10-year bonds compared to safer German debt reached its highest since the launch of the euro on Monday.
Spain's 10-year yields were at 6.47 percent.
The government has said repeatedly it does not need outside financial help but economists disagree.
"The point about Spain is it's going to need some external support of some form," said David Owen, chief European financial economist at Jefferies.
"Whether that implies the European Central Bank buys bonds (in the secondary market) or moves lock, stock and barrel to quantitative easing over the next three-months, certainly the situation at the moment is not sustainable."
Spain has been on an austerity drive to improve its finances but this had boosted unemployment and led to protests, and many economists say it has made the recession worse. Retail sales slumped by 9.8 percent on the year in April, the biggest fall since the series began in 2003.
NO ECB HELP
Spain has been hoping the regional central bank will come to the rescue by restarting its dormant bond-buying program, designed to bring down borrowing costs for countries that have seen them soar during the debt crisis.
The ECB also helped banks, struggling to get access to cash, with two exceptional issues of long-term loans. Many of the banks used the money to buy government bonds.
But ECB policymaker Ewald Nowotny said on Tuesday there had been no discussion of restarting bond purchases or long-term loans and that it was up to national governments to rescue banks.
Foreign minister Jose Manuel Garcia-Margallo said in a television interview said Spain would recapitalize its banks, nursing hundreds of billions of euros worth of toxic assets from a 2008 real estate bust, without international help.
Bankia has asked for a total of 23.5 billion euros, including Friday's 19 billion euros, but many other banks are in trouble, suffering from bad loans that have climbed to an 18-year high.
Garcia-Margallo said decisions about the other lenders would come after an external audit of the sector in June.
Spain is also trying to strengthen the financial system by encouraging a series of mergers.
Liberbank, an unlisted savings bank, said on Tuesday it was in talks about a merger with rivals Ibercaja and Caja 3.
Separately, Popular bank said it had started negotiations to sell a majority stake in its Internet banking business to reinforce its capital position.
The European Commission, which monitors competition issues, said it had been in contact with Spain over the Bankia rescue.
The source said the government was worried the funding needs for the banks could weigh on the capacity of the state to finance itself.
Spain's central government and regions need to refinance 117.5 billion euros of debt by the end of the year, while funding a deficit worth 52 billion euros.
It has already shifted more than 55 percent of its debt issuance for the year but about half of the remaining debt maturing in 2012 will have to be repaid in the last three months of the year, making it imperative borrowing costs have been brought down by then.
The situation is especially difficult in the autonomous regions, with 12 billion euros of debt maturing in the last quarter, more than half of it in Spain's two most-indebted regions Catalonia and Valencia.
The source also said the Spanish government would adopt on Friday a new mechanism to task the Treasury with issuing and distributing debt to the regions, under strict conditions of meeting deficit targets and implementing austerity plans.
"The Treasury will issue and distribute the debt. Strict conditions, such as meeting deficit targets or implementing austerity plans will be attached," the government source said.
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