Spanish borrowing costs jumped at bond auctions on Wednesday, spreading fear in European markets of a return of the euro zone debt crisis and overshadowing a successful step back into debt markets by neighbouring Portugal.
Spain sold 2.6 billion euros (2.15 billion pounds) of debt, at the low end of its target range, with a bond maturing in 2020 yielding an average 5.338 percent, higher than a forecast 5.2 percent and up from 5.156 percent when it was last sold in September.
Concerns Spain will struggle to meet tough deficit targets and repair its ailing banks as the economy shrinks have hampered its debt issuance plans and fuelled concern it might be forced to follow Greece, Ireland and Portugal in seeking a bailout.
Economy Minister Luis de Guindos acknowledged in a Reuters interview that a belief that Madrid may not be able to control its finances was the largest risk the economy faces.
The government was totally committed to reducing the public deficit to 5.3 percent of gross domestic product this year and the EU ceiling of 3 percent in 2013, he said.
The main negative effect, the main risk for the Spanish economy, is the perception that public accounts are not sustainable ... The 5.3 percent commitment is very important but the 3 percent commitment is very, very important, he said.
Spanish risk premiums have leapt since Prime Minister Mariano Rajoy defied Europe in early March by unilaterally easing Madrid's 2012 deficit target. A 27-billion-euro savings plan to shave 3.2 percentage points off the deficit this year has done little to calm nerves.
Spanish economy in graphics http://link.reuters.com/quf25s
The travails of the euro zone's fourth largest economy are in focus for investors who are demanding ever higher premiums to hold Spain's debt on concerns over the political and monetary cost if the bloc has to fund an aid package.
The cost of insuring Spanish and Italian debt against default rose. Spanish yields rose on the secondary market, where the key 10-year bond was up around 25 basis points near 5.7 percent
European Central Bank President Mario Draghi was asked about the rise in Spanish and Italian risk premiums at a news conference following an ECB rate meeting.
Markets are asking these governments to deliver, he said. Without singling out Spain, Draghi said investors were impressed by structural economic reforms and fiscal consolidation launched in several countries but the task remained to be completed.
European shares <.FTEU3> extended their losses after the auction and closed down 2.1 percent. Concern over the Spanish auction also helped drive the euro to a three-week low against the dollar.
Spain has become the focal point for investor anxiety about the euro zone. This is a bout of investor nervousness, the severity of which is difficult to ascertain at this point, said Nicholas Spiro of Spiro Sovereign Strategy.
Yields on 10-year debt had fallen as low as 4.6 percent in late January as cheap European Central Bank cash fuelled a rally in weaker periphery state debt.
Madrid's debt sales have been supported by cheap three-year funds provided by the ECB in December and February. While the ECB has not announced plans for a new round of liquidity, Draghi said any talk of an exit strategy from the central bank's crisis measures was premature.
Spain's banks, which De Guindos said are facing accelerated consolidation, have taken advantage of cheap ECB credit to buy into high-yielding sovereign debt auctions, but attention is returning to fundamentals.
The country's dominant services sector contracted for the ninth consecutive month in March, highlighting the likelihood that the economy fell back into recession in the first quarter for the first time in three years.
Rajoy, who took power just over a 100 days ago, has passed sweeping reforms of the rigid labour market and the financial sector and pushed through some of the deepest spending cuts in Spain's recent history.
More reforms were to come, including a cleanup of the treasured public health and education sectors, De Guindos said, dismissing day-by-day readings of the risk premium as an inaccurate measure of confidence in Spain.
Italian Prime Minister Mario Monti made concessions to the country's biggest labour union and centre-left party on Wednesday, agreeing to soften a planned labour market reform that made it easier for companies to fire employees.
Labour Minister Elsa Fornero said the amended proposal would allow a judge to order the reinstatement of workers fired in the clear absence of business reasons. Monti said the changed package, agreed with the main political parties, would be sent to parliament on Wednesday.
Italy's 10-year bond spread over benchmark German bunds has begun to widen again as Monti ran into trade union and political resistance to his reform drive.
Spain has completed 47 percent of its debt issuance plans for the year in a little over three months. Its heavy sales in the first quarter of the year could well prove significant if bond sales continue to sour.
The average yield of a bond maturing in 2015 was 2.890 percent, up from 2.440 percent when it was last sold on March 15, but below analysts' expectations of around 3.1 percent.
A 2016 bond yielded 4.319 percent compared to 3.376 percent a month ago and analysts' expectations of 3.95 percent.
De Guindos said the increased yields were a reflection of investor nerves over a possible European recession.
The main source of nervousness is the idea, which every day is more widespread and more founded, that we'll see recession in Europe this year, not just in the southern counties, he said.
PORTUGAL TESTS MARKET
Portugal sold 1 billion euros of 18-month T-bills, its longest dated debt since the European Union and International Monetary Fund bailed the country out, with a 4.537 percent yield, compared with 5.993 percent shortly before the rescue.
The auction, which Finance Minister Vitor Gaspar called a successful bet encouraged investors, but failed to quash doubts Lisbon could finance itself fully in the commercial debt market from the second half of 2013 as its bailout deal envisages.
Many investors say Portugal, which is in a deep recession, may need additional rescue funds, and some even express fear of a Greece-style debt restructuring. The EU's top economic official, Olli Rehn, told Finland's MTV3: From the European Union side, it would be wise to be prepared that some sort of bridge needs to be built when Portugal returns to markets.
(Additional reporting by Paul Day, Julien Toyer in Madrid, Ana Nicolaci da Costa in London, Steve Scherer in Rome, Eva Kuehnen in Frankfurt; editing by Philippa Fletcher and Paul Taylor)