Short on a Spanish recovery

Global markets were plunged into despair overnight as panicked investors fretted about the threefold nightmare now unfolding – a full-scale Spanish bailout, a Sicilian debt default, and a Greek exit from the eurozone.

European stock markets dropped sharply, with bank stocks bearing the brunt of the selling. At the close, Frankfurt was down by 3.2 per cent, Paris by 2.9 per cent, and Milan by 2.8 per cent. Spanish shares fell more than 5 per cent before the country's market regulator stepped in and announced a three-month ban on the short-selling of all shares. As a result, Madrid finished only 1.1 per cent lower.

Investors are worried that Spain – the fourth largest economy in the eurozone - is lurching ever closer to needing a full bailout, because the country is finding it increasingly difficult to access capital markets. They fear the subject will dominate crisis talks between German finance minister Wolfgang Schuble and his Spanish counterpart, Luis de Guindos, due to take place in Berlin later today.

Madrid needs to borrow an extra €27 billion this year in order to cover its budget deficit and repay maturing debt. To date, Spanish banks have been avid buyers of Spanish government bonds, but their appetite is now waning, and other buyers are showing little enthusiasm. Overnight, investors dumped Spanish bonds, pushing yields to a dangerous new euro era high of 7.5 per cent. Investors are all too aware that Greece, Ireland and Portugal were all forced to take the humiliating step of requesting a bailout when their long-term bond yields climbed above 7 per cent.

But Spain isn't the only danger zone. Investors are keeping a close eye on Rome, where Italian leader, the austere Milanese Mario Monti will today meet with Sicily's big-spending governor, Raffaele Lombardo to discuss the region's growing financial plight.

Sicily – one of Italy's few autonomous regions and which is referred to as "Italy's Greece” by the Italian media – has seen its budget deficit swell to €5.3 billion (around 6 per cent of the island's output), while its debt burden has jumped to €21 billion. Last week, Standard & Poor's suspended Sicily's BBB-plus rating, saying that Sicily had not provided sufficient information.

Monti has become increasingly worried that Sicily could be on the brink of defaulting, and that Rome will be forced to pick up the tab. He knows that Sicily's public service is bloated, and that its employees are the best-paid in Italy, with some pulling salaries of €17,000 a month. He's also aware that Lombardo's critics regularly accuse him of handing out public service jobs in exchange for votes, and of having close mafia links. For his part, Lombardo has denied that the region is on the brink of bankruptcy, although he did concede it faced a "liquidity crisis” which he said was linked to the general Italian recession.

But Athens remains the biggest concern for investors. Later today, the Greek government will begin talks with the "troika” – officials from the European Union, the European Central Bank and the International Monetary Fund over the country's progress in implementing the budget cuts and economic reforms it promised in exchange for its latest €130 billion bailout.

Athens has acknowledged that it has fallen badly behind, and has requested an extra two years to meet its targets. The problem is that this would require Greece's lenders – the European Union and the IMF – to tip in up to €50 billion in extra funding, which they're very reluctant to do.

Overnight, the German newspaper Sddeutsche Zeitung reported that Germany and other important international creditors were not prepared to give Greece any more money beyond what had already been agreed. At the same time, the German publication der Spiegel reported that the IMF had refused to provide additional financing for Greece.

The troika's report on Greece will decide whether the country gets its next instalment of €31.5 billion under its current bailout program. If the troika decide that Greece has failed to meet its targets, and the next round of aid money is cancelled, Greece could run out of cash within weeks.

Overnight, German Finance Minister Wolfgang Schuble was cagey when asked whether negative reports from the troika would push Greece out of the eurozone. He told the German newspaper Bild: "I won't pre-empt the troika. If there have been delays, Greece must catch up.”