Spanish bond yields at record high

Chancellor Angela Merkel rejected pressure today for Germany to underwrite debt or guarantee bank deposits in the euro zone as Spain's soaring borrowing costs raised new alarm.

Spain's 10-year bond yield today hit a euro lifetime high of 7 per cent - a level above which Greece, Ireland and Portugal were driven to seek international bailouts - despite last weekend's euro zone agreement to lend Madrid up to €100 billion ($125 billion) to recapitalise it ailing banks.

Moody's Investor Service slashed Spain's sovereign credit rating by three notches to Baa3, just one level above junk, last night, adding to the sense of emergency in financial markets ahead of an election in debt-plagued Greece on Sunday.

Dr Merkel, addressing parliament in Berlin, rejected "miracle solutions" such as issuing joint euro bonds or creating a Europe-wide deposit guarantee scheme, backed by other leaders such as new French president Francois Hollande and Italian prime minister Mario Monti.

Such proposals were "counterproductive" and would violate the German constitution, she said. Instead, she called for gradual steps towards the "Herculean task" of building a European political union.

"It is our task today to make up for what was not done [when the euro was created in 1999] and to end the vicious circle of ever new debt, of not sticking to the rules," Dr Merkel said.

She warned against overstraining the resources of Europe's biggest economy, "Germany is putting this strength and this power to use for the well-being of people, not just in Germany but also to help European unity and the global economy," she said. "But we also know, Germany's strength is not infinite."

Italy, rapidly coming into the firing line, saw its three-year borrowing costs spike to 5.3 per cent at auction today, the highest since December, despite Germany's strong expression of support for Mr Monti's reforms when he visited Berlin yesterday.

The surging Spanish and Italian bond yields reflect investors' concern that the 17-country currency union has failed to arrest the debt crisis and faces potential turmoil after a general election that could put Greece on the path to a euro exit.

Mr Hollande said in an interview with Greek television today he wanted Athens to stay in the single currency and it was up to Greek voters to decide what they wished. "But I have to warn them, because I am a friend of Greece, that if the impression is given that Greece wants to distance itself from its commitments and abandon all prospect of recovery, there will be countries in the euro zone which will prefer to finish with the presence of Greece in the euro zone."

He did not name the countries concerned but some German, Dutch and Austrian officials have spoken openly of a possible Greek exit.

In the last opinion polls published before a blackout 10 days ago, the leftist Syriza party, which rejects the terms of Greece's EU-IMF bailout, was running neck-and-neck with the conservative New Democracy party, raising the possibility of a radical anti-austerity coalition or another deadlock.

Greeks, who have endured four years of recession and now have 22.6 per cent unemployment, have been pulling hundreds of millions of euro money out of the banks and stocking up on food ahead of the election, fearing worse turmoil after the vote.

Greece's debt woes have helped push neighbouring Cyprus to the brink of seeing a financial rescue, with officials looking to Europe, Russia and China for the best possible bailout terms.

Dr Merkel acknowledged that the euro zone crisis, and Germany's role, would be at the centre of attention at next week's summit of the G20 major world economies in Los Cabos, Mexico. The leaders gather on Monday, a day after the Greek election.

US president Barack Obama, whose re-election prospects in November could be dented by the euro crisis, telephoned European Council president Herman Van Rompuy yesterday to ask how Europe planned to cope with the outcome of the Greek vote.

US treasury secretary Timothy Geithner said the world would be looking to Germany and other EU countries to provide clarity on plans for a euro zone banking union, a financial firewall and how Europe can revive economic growth. But he said it would be unfair to see Germany as the sole source of the problem in the euro zone.

"Germany is saying make monetary union work. We are prepared to be behind this broader endeavour, you need to be in support of reforms," Mr Geithner told the Council on Foreign Relations in Washington last night, adding that other countries needed to move toward Germany's position.

Reuters