Spain and Italy staring over precipice as risk premium hits record highs

Spain's risk premium on Monday broke through 300 basis points for the first time since the euro came into existence as the debt crisis in the single-currency bloc extended its tentacles to Italy, sending shock waves through the single-currency system.

The differential between the yield on the Spanish benchmark 10-year government bond and the German equivalent closed at a record 335 basis points after opening at 307 basis points. It had closed around 285 basis points on Friday when contagion from Italy was already evident as doubts about the country's ability to service its debt grew. Italy's risk premium widened to 303 basis points, more than double the level it stood at in April.

The Spanish blue-chip Ibex 35 index extended Friday's heavy losses and closed down 2.69 percent at 9,670.60 points. Banks suffered the brunt of selling across Europe. In Spain, Caixabank lost 4.29 percent, BBVA 4.06 percent and Santander 3.16 percent. That augured badly for Bankia and Banca Cívica, which are due to hold initial public offerings in what are regarded as key tests of the ability of savings banks that have converted to commercial banks to tap the markets. Portuguese government bonds also slumped, while the benchmark PSI-20 in Lisbon fell 4.28 percent.

"You can clearly see the market is worried," Bloomberg quoted Michael Leister, a fixed-income analyst at WestLB in London, as saying. "We are seeing a self-fulfilling prophecy, where yields increase due to contagion and then the market gets worried about the high funding costs, as do the rating agencies."

The scene was set by European Union President Herman van Rompuy's decision to call a surprise meeting of EU leaders to discuss Italy and a second rescue package for Greece.

Germany's Die Welt reported Sunday that the European Central Bank is seeking to double the size of the European emergency fund to 1.5 trillion euros.

Van Rompuy called a working breakfast meeting with ECB President Jean-Claude Trichet, the head of the Europgroup, Luxemboug Prime Minister Jean-Claude Juncker, and the European commissioner for economic affairs, Olli Rehn, ahead of a euro-area finance ministers meeting to be held later Monday in Brussels.

Spanish Prime Minister José Luis Rodríguez Zapatero said Monday that "the process of a lack of confidence is spreading to more countries." Zapatero insisted that the reforms undertaken by his government are key to winning the confidence of investors.

German Chancellor Angela Merkel said Monday that the euro remained a strong currency despite the problems caused by the debt crisis in some of EU countries. Merkel said she has "absolute confidence" in the Italian government's ability to fulfill all of its financial commitments.

Spanish Economy Minister Elena Salgado said Italy can pull through without the need for financial aid. The Italian government is looking to push austerity measures of around 40 billion euros through parliament as part of its efforts to trim the country's budget deficit.

Both Moody's Investors Services and Standard & Poor's have warned about possible ratings cuts for Italy due to weak economic growth and high debt of over 120 percent of GDP.

There are also concerns Italian Finance Minister Giulio Tremonti may be pushed to resign in connection with a scandal involving a former adviser.

On top of that there are fears Italian banks will fare badly in the stress tests carried out on European banks, the results of which are due to be made public this week. Salagdo said some of Spain's savings banks may also fail the tests, which this time around do not include generic provisions in capital.