Doubts arise over Madrid's ability to prop up its banks

Spain seemed to be moving closer to an official bailout yesterday as the country's borrowing costs soared and doubts over the ability of the Madrid government to prop up its ravaged banking sector multiplied.

The yield on Spanish 10-year bonds rose to 6.48 per cent in trading, with the spread over Germany's 10-year borrowing costs hitting their highest levels since the foundation of the single currency at 505 basis points.

The interest-rate spike was a response to growing fears about the solvency of the country's banks, which are still hobbled by bad loans made to the country's collapsed construction sector. Investors were unnerved, in particular, by reports that the centre-right government of Mariano Rajoy is planning to recapitalise its fourth largest lender, Bankia, by issuing the bank with sovereign bonds, rather than injecting cash.

Analysts said that the proposal showed that it is prohibitively expensive for the Spanish government to raise new money in the debt markets. While the move could offer a quick financial fix since Bankia would swap those sovereign bonds for cash at the European Central Bank, it would further entwine the fate of the Spanish government with that of its banks and thus increase the risk that both could, ultimately, collapse together.

According to data from the Bank of International Settlements, Spain's banks are already holding 30 per cent of the county's sovereign debt. They have been the largest purchasers of Spanish bonds since the turn of the year, helping, until recently, to keep sovereign yields down.

Bankia announced last Friday that it would need €19bn (£15bn) from the government. Yesterday its shares fell by 13 per cent.

Although Mr Rajoy insisted at a news conference yesterday that Spain will not apply for external help to rescue its banks, he did back calls for the eurozone's new incoming bailout fund, the European Stability Mechanism, to be allowed to lend to the continent's banks directly.