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* 7 percent seen as psychological, not based on calculations
* Spain and Italy may be able sustain that level for longer
* Bank recapitalization funding needs makes Spain vulnerable
By Ana Nicolaci da Costa
LONDON, June 1 (Reuters) - The market's view that 7 percent is an unsustainable borrowing cost for euro zone economies has more to do with psychology than mathematics.
After yields in Greece, Portugal and Ireland rose above that level, the cost of issuing new debt quickly spiked and those countries were forced to seek international aid.
With Spanish 10-year yields approaching that no-go level, traders are anticipating the euro zone's fourth-largest economy may need outside help. In preparation, they are selling Spanish government bonds and pushing funding costs even higher.
That's creating a vicious circle that could precipitate a bailout the euro zone can ill afford.
"Seven percent is a number picked from the skies, because roughly that's the level at which previous countries were embraced into the (bailout) programmes," David Keeble, global head of fixed income strategy at Credit Agricole, said.
"That's why we get a little bit spooked about it, but it's really not a mathematical issue."
Concerns over Spain's ability to recapitalize its overleveraged banking sector without running out of funds have fuelled the recent rise in the country's borrowing costs. And the higher they get, the more markets worry about Spain's finances.
A rescue would likely fuel contagion and deplete the euro zone's firewall against further contagion, leaving little left for Italy if its debt problems also come to a head.
But some analysts say 7 percent borrowing costs could be affordable for economies as big as Spain and Italy, at least for some months.
Interest payment on a country's debt is determined by the average cost of borrowing for its overall debt.
Only new issuance carries interest rates in line with yields in the secondary market, so that the average cost of the debt load would only be affected gradually, some analysts note.
Given the size of Spanish and Italian debt markets, it may take longer for 7 percent yields to filter through into the country's overall financing costs than it did in the case of other countries, they say.
"The point is that both Spain and even Italy to a greater extent have very large debt stocks. And that debt stock is at fairly long maturity," James Nixon, chief European economist at Societe Generale, said.
"The impact (of higher yields) on its debt servicing costs only begins to snowball gradually as the redemptions come through," Nixon added.
Spain has 628 billion euros ($776.5 billion) worth of outstanding debt, compared with 158 billion euros for Portugal in April 2011 before it received international help.
The average borrowing cost for Spain's debt is at 4.07 percent, much lower than the 6.5 percent currently offered by 10-year Spanish bonds.
The average maturity of Spain's debt is 6.55 years, compared with 5.7 years for Portugal in April 2011.
One reason markets focused on 7 percent yields in Portugal's case is because the finance minister effectively told them to.
Finance Minister Fernando Teixeira dos Santos said in October 2010 that yields settling above 7 percent would be unsustainable for Portugal.
"He said that and the market leapt on this," John Davies, fixed income analyst at WestLB, said.
Less than two months later, Portugal accepted a bailout.
However, Davies said 7 percent was no magic number. "People (are) applying 7 pct to Portugal, Spain and Italy and its quite clear that these are three different economies, with three different levels of debt-to-GDP."
Either way, the 7 percent mark has stuck, and given the herd mentality a break above that level for Spain could bring funding costs much higher very quickly.
Spain has already completed 54.5 percent of this year's 86 billion euros worth of planned issuance.
But at a time when the country may have to issue new debt in order to recapitalise its banks - the result of a burst property bubble aggravated by recession - rising borrowing costs may well shut Spain out of markets quicker than its fundamentals would suggest.
Barclays said in a recent research note that even though Spain is well advanced in its bond issuance, the prospect of extra issuance for bank recapitalisations will continue to weigh on Spanish markets.
"We would estimate that Spain would probably have to issue at least 50 percent more than their original target for the year, and where is the bid going to come from?" one trader said.
He pointed out that the premium over German Bunds investors require to hold 10-year Spanish debt was already above 500 basis points - heading towards levels at which those countries eventually sought bailouts.
"Spain has been 500 (bps) over Germany for ... (five) days now. Greece lasted 16 days of 500 over, Ireland 24, and Portugal 34 days respectively. So how long can Spain last at 500 over? That's my worry."