Spain's key borrowing rate hit a fresh high Thursday not seen since the country joined the euro in 1999, after a credit ratings agency downgraded the country's ability to just above junk status amid rising fears a bank bailout may not be enough to save the country from economic chaos.

The interest rate — or yield — on the country's benchmark 10 year bonds rose to a record 6.96 per cent in early trading Thursday, close to the level which many analysts believe is unsustainable in the long term and the rate that forced Greece, Ireland and Portugal to seek bailouts of their public finances.

The ratings agency Moody's downgraded Spain's sovereign debt three notches from A3 to Baa3 Tuesday night, leaving it just one grade above "junk status".

Moody's said the downgrade was due to the offer from eurozone leaders of up to €100 billion to Spain to prop up its failing banking sector, which the ratings agency believes will add considerably to the government's debt burden.

Three reasons not to like the Spanish bank rescue plan:

  • If the Spanish banks go bust, existing bond holders get paid whatever’s left after the EU. That means the market value of those bonds will fall if the plan goes ahead, weakening the balance sheets of the banks and requiring them to borrow even more.
  • Spain is ultimately responsible for the loan. The increase in borrowing this represents is expected to boost its debt to peak at around 105 per cent of GDP by 2017.
  • Those countries bankrolling this bailout — the stronger EU members — may see their credit ratings fall because of their increased risk exposure.

Source: TD Bank

The lowered score means that even fewer investors will buy Spanish debt, because organizations like pension funds are mandated to avoid assets with such low creditworthiness.

Spain won't immediately collapse if the rate hits seven per cent, but reaching that point would affect Spain next week when it is scheduled to auction debt.

"The clock is definitely ticking," said Michael Hewson, an analyst with CMC Markets.

The bank bailout is intended at recapitalizing the Spanish banking system and calming Europe's debt crisis.

Instead, investors seem unnerved by the government taking on extra debt and have pushed Spanish bond yields — a measure of market jitters — higher all week.

Moody's said the Spanish government's ability to raise money on global markets was being hindered by high interest rates, a situation which had led it to accept eurogroup funds to recapitalize debt-burdened banks.

Some details of what the bailout might look like began to emerge Thursday. European officials are considering liquidation —selling off a bank's assets — as part of the plan to prop up the Spanish banking sector, a spokesman for Competition Commissioner Joaquin Almunia said.

"Liquidation is always looked at," said Antoine Colombani. "We prefer to liquidate when it's cheaper for the taxpayer."

Since a weekend agreement to save the banks involves first lending the money to Spain, there are concerns that taxpayers are ultimately on the hook for the banks' bad decisions. Also, investors are worried that the deal raises Spain's debt and deficit levels.

Eurostat, the European statistics agency, said Wednesday that it was unclear how much the country's deficit would rise because it depended on how it lent the money on to the banks. Part of that decision will depend on the interest rate the banks are given.

If it's too low, it could be considered more a gift than a loan and would count against the deficit.

Colombani said that under one plan being considered, the minimum for the rate would be 8.5 per cent. Eurostat did not immediately respond to questions about whether that would be high enough to avoid having the loans count against deficit.

Meeting to be tense

Part of Almunia's role is to help countries deal with troubled banks, and he will travel to Madrid on Friday to meet with Prime Minister Mariano Rajoy.

The meeting is expected to be tense. Rajoy's conservative Popular Party on Thursday accused Almunia, former leader of Spain's Socialist Party, of "disloyalty" and demanded his resignation because he has revealed details of the bank bailout plans before Rajoy's administration.

Almunia was sent to Brussels by former Socialist Prime Minister Jose Luis Rodriguez Zapatero in 2004.

"The only thing he does is attack the interests of Spaniards, causing panic and terrible consequences for everyone," said Rafael Hernando, the Popular Party's spokesman in parliament.

The Spanish government's erratic response to the crisis has irritated European Union leaders, Spain's leading newspaper El Pais said on its front page Thursday.

The paper said Rajoy has come under criticism in EU circles for presenting the bailout as a "light" measure and a victory for Spain and the euro, leading to an outcry for similar treatment by other austerity-saddled bailout countries such as Portugal and Ireland, which have had to struggle with heavy, externally imposed fiscal controls.

'Spain is implementing the right reforms.' —German Chancellor Angela Merkel

Speaking to the German parliament in Berlin on Thursday, Chancellor Angela Merkel insisted: "Spain is implementing the right reforms."

"The Spanish Prime Minister is doing this with great courage and great determination," she added.

Merkel again welcomed Spain's move to apply for European funds to recapitalize its banks.

"We know banks must be reasonably capitalized to keep the economy afloat, that is the lesson from 2008, 2009," she said.

"The faster Spain gets the application done, the better," she said.

Spain's benchmark stock index, the IBEX-35, opened lower Thursday but recovered to close with a gain of 1.22 per cent.

The 10-year bond yield eased slightly to 6.89 per cent.