Spain insisted Friday it is financially stable because its heavily indebted regions are now meeting deficit reduction targets, but investors remained worried about the country's ability to rescue another part of its financial system - the banks - and kept the government's bond yields dangerously high.
The nation's 17 semi-autonomous regions - whose high debts have helped fuel fears about the country's financial future _ will meet a target to get their collective deficits below 1.5 percent this year, Finance Minister Cristobal Montoro told reporters.
The regions, which function much like U.S. states, ran a deficit of 0.45 percent of GDP in the first quarter. When counting (EURO)5 billion ($6.2 billion) they received from the central government, they ran a balanced budget.
"This means that since the beginning of the year the government's plan is working," said Montoro.
Most of Spain's excessive deficits in 2011 _ which at 8.9 percent were almost three times the EU limit of 3 percent _ came from the regions' overspending.
Eight of the regions, including powerful Catalonia in the northeast, saw their credit ratings downgraded this week by the Fitch agency. Those that issue debt are paying high rates. Montoro said the government is close to completing a mechanism that will allow the regions to issue debt through the central government at lower rates.
But worries about Spain in recent weeks have centered mainly on its banks, which are sitting on massive amounts of soured real estate investments. Rescuing the banks could overwhelm public finances, pushing the government to need international aid itself.
Those concerns remained as strong as ever on Friday and one senior bank executive said that if the amounts of money needed to rescue the country's banking sector kept on getting bigger there would be no alternative to a European bailout, the first time the head of a bank has acknowledged such a possibility.
"The banking sector is now in an absolutely critical situation," said Maria Dolores Dancausa, chief executive of Bankinter SA, Spain's seventh-largest bank by market value. "With the figures needed to clean up the banks going each time higher it gets to look like there will be no choice," Dancausa said.
The interest rate on 10-year Spanish bonds was up another 0.02 percentage points to 6.47 percent, close to the 7 percent rate that forced Greece, Ireland and Portugal to ask for bailouts.
Despite the rise in borrowing rates, Montoro insisted the country can meet its debt obligations: "Spain has the ability to make good on that debt in its entirety."
Concern about Spain and the wider 17-country eurozone has shaken financial markets in recent weeks, pushing the euro to a 2-year low on Friday.
Spanish Economy Minister Luis de Guindos said this week that Spain and Europe were at a crossroads as speculation mounts over whether the country will need a bailout. The danger is that Spain's (EURO)1 trillion ($1.24 trillion) economy is too big for Europe to save _ far larger than the economies of Greece, Ireland and Portugal combined.
Spain's banking sector is laden with soured investments on real estate and the government needs (EURO)19 billion to rescue just one lender, Bankia SA, at a time of recession and crushing unemployment of 24.4 percent.
"I don't know if we are on the edge of a cliff, but we are in a very, very difficult position," de Guindos said Thursday evening in a speech to business leaders in Sitges, a resort town near Barcelona. "The future of the euro is going to play out in the next few weeks in Spain and Italy."
Bond yields _ a measure of investor confidence in a country's debt _ were also very high in Italy, which has big debts and is in recession. Its 10-year bond yield rose stood at 5.73 percent late Friday afternoon after rising to 5.93 percent earlier in the day on fears that it could be affected by Spain's instability.
UBS Investment Research said there is no consensus that the Spanish banking sector in general needs a big recapitalization. It estimated the sector needs between (EURO)80 billion and (EURO)100 billion in new funds.
"The Spanish State should be able to sustain the recapitalization costs without losing control of its finances," UBS analysts said in a note to clients. "We recognize however that financing this intervention in current market conditions will be difficult."
De Guindos supported the recent proposal by the European Commission for a centralized banking authority with the financial capacity to inject capital directly into troubled banks without having to go through governments first.
He also said Europe needs a regional bank deposit insurance plan like the United States has and a "banking union" to coordinate regulation among countries.
Germany, however, opposes the idea of a centralized authority that can spend money _ much of which Berlin supplies _ directly on shaky banks.
"We don't see now how such ideas are supposed to help with the short-term management of the current questions," said German Finance Ministry spokesman Johannes Blankenheim. "The fiscal compact is the beginning of the fiscal union and, as a perspective, one can imagine stronger (banking) supervision."
Top financial officials, however, have been warning European leaders they must take action before it is too late.
European Central Bank head Mario Draghi said this week that the setup of the eurozone was unsustainable and called for measures, such as a banking union, as proposed by the European Commission.
World Bank chief Robert Zoellick made similar points in an opinion piece published Friday in the Financial Times.
"Eurozone leaders may be nearing a `break the glass' moment: when one smashes the pane protecting the emergency fire alarm," Zoellick wrote. He also supported the idea of having a central European authority that can put money into ailing banks.
Despite its resistance to such a move, Germany did back the European Commission's proposal to give Spain more time to reduce its deficit. It stood at 8.9 percent of GDP last year, and the goal is to get it down to 5.3 percent by the end of 2012.
Blankenheim noted that Spain has stated its intention of cutting the deficit to 3 percent by next year, "but we also see that, because of unfavorable economic developments, it could be difficult to reach these targets."
"Spain is fulfilling its commitments in the deficit proceedings and so there is no reason to escalate the proceedings against Spain," Blankenheim told reporters in Berlin. "The Spanish government is tackling with determination the necessary reform measures, and the German government is convinced that this determination will be mirrored on the markets."
Geir Moulson in Berlin and Harold Heckle in Madrid contributed to this report.