Spain is battling to avert a fully-fledged sovereign rescue after borrowing costs spiralled out of control, with dangerous knock-on effects in Italy and Eastern Europe.

The yields on closely-watched two-year debt surged by 78 basis points to a modern-era high of 6.42pc, leaving it unclear how long the country can continue funding itself. Italy’s two-year yields vaulted to 4.6pc.

“We can’t keep going like this for another 15 days,” said Prof Miguel Angel Bernal from Madrid’s Institute of Market Studies. “The European Central Bank has to bring out its heavy artillery.”

Andrew Roberts, credit chief at Royal Bank of Scotland, said the dramatic spike in short-term borrowing costs marked a key inflexion point in the crisis, replicating the pattern seen in Greece, Ireland and Portugal as they lost access to market finance. “We are fast approaching the endgame,” he said.

Exchange clearer LCH Clearnet raised margin requirements on both Spanish and Italian bonds, a move that will automatically cause further selling by some funds.

Confidence has evaporated since Germany effectively blocked plans for the European Union bail-out machinery to recapitalise the Spanish banking system directly, as originally announced after the EU summit deal in June.

The EU’s €100bn (£78bn) package will be a loan to the Spanish state. This fails to sever the fatal link between banks and vulnerable states, each pulling the other down.

The mood has gone from bad to worse as Spain’s regional governments line up for internal rescues, with Catalonia preparing a €3.5bn bail-out request following moves by Valencia and Murcia in recent days. The regions must roll over €15bn of debt by the end of the year.

The Spanish newspaper El Confidencial reported sources close to premier Mariano Rajoy complaining bitterly that the crisis engulfing Spain was a “failure of the whole European Project and the incompetence of its leaders”.

There is deep shock in government circles that the €65bn austerity package passed by the Spanish parliament last week amid bitter protests across the country – and imposed by the EU – has failed to make any difference.

El Confidencial said the Rajoy team was thinking of “putting on the table” a possible withdrawal from the euro, a dramatic escalation in the game of brinkmanship between the eurozone’s Latin bloc and German-led creditor core.

“We would have our own currency again and restore competitiveness. It would have some disastrous consequences at first, but we would regain control over our own policies and we would escape from the crisis sooner,” a government source reportedly said.

Spain has enough funds to muddle through into the autumn, but it is under mounting pressure from the EU authorities to swallow its pride and accept rescue to halt contagion to Italy, where bond yields are testing danger levels.

Joaquin Almunia, the European Competition Commissioner, said the proper course of action at this stage was direct purchases of Spanish debt by the eurozone bail-out fund (EFSF). “Spain can’t do this alone,” he said.

The surge in Spain’s short-term yields adds another twist to the banking crisis, a cost that now falls on the state. Spanish banks borrowed €315bn from the ECB under the long-term refinancing operation (LTRO) and “parked” a large chunk in Spanish two-year to five-year sovereign bonds until they need the money to cover their own debt rollovers.

While this so-called “carry trade” helped to stabilise the Spanish bond market for a few months during an exodus by foreign investors, it has now backfired badly. The two-year bond has shed 9pc in face value since the second LTRO in February, leaving the banks heavily under water. “This has turned into an unmitigated disaster. They will have to crystallise these losses when they sell,” said Mr Roberts.

The latest Fiscal Monitor by the International Monetary Fund has pencilled in public debt to GDP of 96pc in Spain by next year, up from 84pc just two months ago – a sign of how quickly the situation is snowballing out of control.

Gary Jenkins from Swordfish said the EU may be able to “rustle up” just enough money to finance an EU-IMF Troika rescue for Spain – probably around €400bn – but Italy is too big to handle.

The existing EU bail-out fund (EFSF) is down to about €160bn after covering the needs of Greece, Ireland, Portugal, Cyprus and the Spanish banks. The new permanent fund (ESM) will have €500bn, but is facing a challenge in the German constitutional court. It is far from clear whether these funds can raise large sums on the open market at viable cost.

Mr Jenkins said the fire must be contained before it reached the next big country, either by massive ECB intervention or full fiscal union. Germany is still blocking both. “The battle for Spain is already lost. The battle for Italy has begun,” he said.----

Source: http://www.telegraph.co.uk/finance/financialcrisis/9422001/Eurozone-danger-mounts-as-Spain-spins-out-of-control.html