MADRID Spain's banks may need more capital if the economy deteriorates, the head of the central bank said on Tuesday, reflecting fresh concerns that some might not survive a recession made worse by the government's austerity drive.
Spanish lenders were bruised by the 2008 property crash and have been under scrutiny since the euro zone debt crisis deepened last year. But a recent surge in loan defaults in other sectors has put them back under the spotlight again.
Investors are worried the banking troubles may force Spain to take a bailout like Greece and neighboring Portugal and sold Spanish bonds on Tuesday, sending yields up to levels not seen since December.
The government has ruled out a bailout and Prime Minister Mariano Rajoy announced new spending cuts on Monday in a bid to meet a stringent European Union deficit limit.
The EU welcomed the savings but many analysts fear they will lead to a deeper recession, a scenario that Central Bank Governor Miguel Angel Fernandez Ordonez said could mean banks will need more capital.
"If the Spanish economy finally recovers, what has been done will be enough, but if the economy worsens more than expected, it will be necessary to continue increasing and improving capital as necessary in order to have solid entities," he said at a conference in Madrid.
The economy is forecast to contract by 1.7 percent this year but is likely to deteriorate further as the government slashes 27 billion euros from the central budget, and billions more from spending in the country's 17 autonomous regions.
Ordonez said it was unlikely the country would experience a strong recovery in the short-term.
"The solutions to the crisis, which came from excessive debt or loss of competitiveness, are very slow within a monetary union and that is why we can't afford to become complacent," he said.
The latest banking reform, introduced two months ago, urged banks to put aside around 50 billion euros of provisions to mop up real estate losses and encouraged mergers and costs savings without dipping into state funds.
The government says it will not need to inject more state aid into its banks, but many analysts are skeptical that simply forcing weaker rivals into the arms of more solvent players will be enough to fill funding gaps.
BONDS UNDER PRESSURE
A weak auction of Spanish bonds last week underscored investor concern over the economy.
Spanish 10-year yields were 17 basis points higher at 5.95 percent after rising around 25 basis points last week. The spread over German Bunds is at its highest since early December, before the European Central Bank flooded banks with cheap three-year liquidity.
Italian bonds are also under pressure because analysts see it as vulnerable to Spanish problems.
"Spain is right in the center of a European storm...But if we adopt the right policies, I have no doubt that the Spanish economy will come out of this situation," Economy Minister Luis De Guindos said at a separate conference.
Rajoy announced Spain would save 10 billion euros in health and education, a move welcomed by the European Commission.
"What was decided yesterday confirms both the Spanish government's determination to implement the necessary reforms, and...the Spanish government's commitment to respect the 5.3 percent deficit for 2012," said Commission spokesman Olivier Bailly.
In addition to central government cuts, investors are closely watching the finances of the autonomous regions, which overspent last year.
"Of course, it will ultimately fall to the regions to implement their budgets," said Barclays in a note to clients.
"We think market confidence will only be restored if the (quarterly) fiscal performance of the region governments (and the central government) shows they are implementing their budget according to plan."
(Writing by Sarah Morris; Editing by Julien Toyer and Anna Willard)