Spain's borrowing costs shot up at a bond auction today, after economic data confirmed the country is back in recession and reports that nationalised Bankia SA had suffered an outflow of deposits hammered its share price.

The Spanish Treasury had to pay around 5 per cent to attract buyers of three- and four-year bonds. The longer-dated paper sold with a yield of 5.106 per cent, way above the 3.374 per cent the last time it was auctioned.

Spanish prime minister Mariano Rajoy warned yesterday that his government, struggling to reduce its budget deficit, could soon find it difficult to fund itself affordably on the bond market unless the pressure eases.

"This ... fits the pattern of recent sales, with the Spanish treasury successfully getting its supply away but at ever-higher yields," said Richard McGuire, rate strategist at Rabobank in London.

"This unfavourable trend looks set to remain firmly in place ... Ultimately, this ratcheting up of yields will likely require some form of outside intervention.”

Spain's 10-year yields have spiked back above 6 per cent, which investors view as a pivot point that could accelerate a climb to 7 per cent, a cost of borrowing widely seen as unsustainable even though Madrid has sold well over half its debt needs for the year.

The premium investors pay for Spanish over German debt rose to its highest level since the euro's introduction this week, at over 500 basis points.

Top of the heavily indebted country's worry list is a banking sector beset by bad loans, the result of a property boom that bust in spectacular fashion.

El Mundo newspaper reported that customers at troubled Bankia had taken out more than €1 billion, equivalent to around 1 per cent of the lender's retail and corporate deposits, over the past week in a sign of fast-fading faith in the lender.

The government took over Bankia, the country's fourth largest lender and which holds around 10 per cent of Spanish deposits, last week in an attempt to dispel concerns over its ability to deal with losses related to the 2008 property crash.

The bank's shares plunged more than 20 per cent, having shed 10 per cent yesterday after it delayed publishing fourth-quarter results, stoking fears over the scale of losses it faces.

"The majority of outflows came after the chairman resigned last week, but I think once the bank was taken over by the government, depositors calmed down a bit," said one Madrid-based trader. "The share price fall has to do with disappointed retail investors dumping the stock."

The problem for Madrid is that property losses facing banks are not yet quantifiable, given prices are likely to fall further.

The government told the sector last week to set aside another €30 billion in provisions.

A government spokeswoman said the bidding process to select an external auditor to value real estate assets across the banking sector was still open, denying Oliver Wyman and BlackRock had been chosen as sources previously told Reuters.

While Greece, facing fresh elections which could hasten its exit from the euro zone, has dominated headlines, uncertainty over the final cost of Spain's banking reform has stoked investor fears it could require an expensive international bailout, a bill the euro zone would be stretched to cover.

Stuart Gulliver, head of Europe's biggest bank HSBC, reflected on his biggest external concerns.

"It's absolutely how the euro zone plays out and whether Greece stays in, and/or whether firewalls are high enough to protect Spain and frankly whether markets take things into their own hands before (Greek elections on) June 17th," he said.

Official data confirmed the Spanish economy shrunk by 0.3 per cent in the first quarter, putting it back into recession and facing a prolonged downturn as the government cuts spending in an attempt to wrestle down its budget deficit.

Unemployment is already running close to 25 per cent with half of the young without a job.

Expansion of the export sector, the only area of Spain's economy to have grown in the last two quarters, slowed in the first quarter as the country's main trading partners in Europe saw their own economies contract.

Spanish finance minister Cristobal Montoro meets heads of finance of all 17 regions later to review their budget plans which are a crucial plank of the drive to lower public debt.

Even if it puts its house in order, Madrid faces the threat of contagion from Greece if it elects an anti-bailout government next month, a move which could hasten a hard default and exit from the euro zone.

"It's not Greece leaving the euro that is the major issue," said John Bearman, chief investment officer at Thomas Miller Investment. "It's the domino effect."

Reuters