Spain's borrowing costs lurched higher and the Madrid stock market hit a nine-year low on Wednesday as investors rattled by deepening fears about its banking system fled to the relative haven of German bonds.

Spain's banking woes - the result of a burst property bubble aggravated by recession - have combined with growing uncertainty about Greece's survival in the euro zone to reignite Europe's sovereign debt crisis, driving the euro to a two-year low of $1.2454. European shares also extended their fall after Italy paid heavily to sell bonds.

Madrid said it will probably tap credit markets to inject funds into nationalised lender Bankia, but that looks expensive with 10-year borrowing costs at 6.67 percent near their euro era peak and close to levels at which Ireland and Greece sought international bail-outs.

The Economy Ministry played down a Financial Times report that the European Central Bank had rejected an initial plan to rescue Bankia, Spain's fourth biggest bank, by stuffing it with government bonds that could be used as collateral to borrow from the ECB.

'Spain did not formulate any proposal to the ECB on funding the Bankia plan, so it was difficult for it to have an opinion,' a ministry spokeswoman told Reuters. 'The Economy Ministry maintains as a first option to go to the markets to recapitalise the entity.'     

The Frankfurter Allgemeine Zeitung, an influential voice in the conservative German financial establishment, said that by considering such 'tricks', Spain was provoking the market distrust it sought to avoid at all costs.

Investors unnerved by Spain's deepening financial crunch,  pushed Italy's funding costs sharply higher at a bond sale, with 10-year yields topping 6 percent for the first time this year.

In a sign of heightened anxiety in Washington, top US
Treasury official Lael Brainard was despatched to hold talks in Greece, Germany, Spain and France 'to discuss their plans for achieving economic stability and growth in Europe', the Treasury Department said.

A sudden economic deterioration in Europe would pose a serious threat to the US economy and hence to President Barack Obama's re-election prospects in November.

Spanish Prime Minister Mariano Rajoy has insisted the government has no intention of seeking an EU/IMF bailout either for its banks or for the state.

But the abrupt resignation of Bank of Spain Governor Miguel Angel Fernandez Ordonez on Tuesday, a month before his term was due to end, added to market concerns about the handling of the Bankia crisis and relations with European institutions.
 

Highlighting Spain's difficulty in meeting fiscal targets while gripped by a worse-than-forecast recession, the outgoing central bank chief said tax revenue may fall short of government estimates and spending may be higher than expected.

He recommended bringing forward a rise in value-added tax set for 2013 if the deficit objective goes off track this year. - Reuters