Europe will grant Spain an extra year to reach its deficit targets after it outlines further budget savings to finance ministers meeting in Brussels.
Although no final decision is expected at a Eurogroup meeting of eurozone finance ministers for a bailout of Spain's banks, a wider gathering of EU finance chiefs on Tuesday is set to ease a debt goal that has pressured Madrid to make punishing cuts that are exacerbating a recession.
Spanish and Italian borrowing costs continued to rise on Monday towards levels considered unsustainable in the long term as investors saw little chance of a respite in the eurozone's debt crisis from the Brussels meetings.
"Spain's budget consolidation targets will be adjusted to give it an extra year," said one of the diplomats.
"This is not a unilateral move. Spain needs to make the necessary cuts to reach that goal and this will be discussed on Tuesday at the Ecofin [meeting of ministers]. I expect the extra year to be granted."
The European Commission will propose easing Madrid's deficit goal for this year to 6.3% of economic output, 4.5% for 2013 and 2.8% for 2014, officials said.
The new figures highlighted Spain's dramatic fiscal slippage. Madrid was originally supposed to cut its budget shortfall to 4.4% this year. Prime Minister Mariano Rajoy unilaterally changed the target to 5.8% in March before eventually accepting an agreed goal of 5.3%.
The commission will make the new proposal on Tuesday to the EU's finance ministers, who would have to agree for the targets to become binding, two officials told Reuters.
Spanish Economy Minister Luis de Guindos will spell out at the meeting his government's plan for a package of up to €30-billion over several years through spending cuts and tax hikes that are due to be announced this Wednesday.
A source close to the Spanish government said €10-billion of cuts would come this year and that the measures would include a VAT hike, reduced social security payments, reduced unemployment benefits and changes to pensions calculations.
Madrid had been due to reduce its national deficit to 3% of gross domestic product by the end of 2013. But a deep recession has put that beyond reach.
A decision on the full details of a crucial rescue for the country's banks is also due.
A Spanish government source said it would sign a memorandum of understanding on Monday in Brussels regarding the rescue, which would be followed on July 20 by a full loan agreement. As part of that, it will agree to create a single bad bank to house toxic assets from its banking sector.
Spain has requested a bailout of up to €100-billion. While it strives to cut its debts and shore up its struggling banks, it has pleaded for help to get down its borrowing costs. Spanish 10-year government bond yields above 7% are not sustainable indefinitely.
"At this moment the only institution that has enough money to act is the ECB," Spanish Foreign Minister Jose Manuel Garcia-Margallo said at a conference. "For that reason, the ECB should intervene in markets, it should start massive purchases of public debt so that speculators understand that they will lose their bets against the euro."
The European Central Bank has proved markedly reluctant to revive its bond-buying programme.
Alongside Spain, eurozone ministers will also be confronted with the need to decide on a new structure for cross-border banking supervision, how to use eurozone bailout money, aid to Cyprus and whether to grant concessions to Greece, which has admitted it is missing its bailout programme targets.
A key part of a plan agreed by euro zone leaders at a summit last month is to give the ECB a central role in the cross-border supervision of banks, which would then allow the permanent rescue fund – the European Stability Mechanism (ESM) – to recapitalise banks directly instead of via governments.
ECB president Mario Draghi, testifying to the European Parliament before ministers meet, called on governments to fully implement promised economic reforms and governance improvements to remove tension in financial markets.
Eurozone countries needed to send a message to investors that "The euro is here to stay – and the euro area will take the necessary steps to ensure that," he told lawmakers.
Draghi praised Portugal's progress with its EU/IMF adjustment programme, said Spain remained fully committed and lauded Italy's public spending review, but he said some indebted countries were slipping into recession because they were raising taxes instead of cutting spending. He appeared to be referring notably to France.
EU leaders want to break the link between banks and sovereigns by not lumbering governments with debts for rescuing their lenders, making it harder for them to borrow.
They also decided that eurozone rescue funds can buy government to lower borrowing costs, with some conditions attached but without a full programme.
Much depends on the ECB's role as supervisor, which will need to be grounded in European law. It falls to the European Commission to propose such legislation, which is not expected until at least September.
Despite the obstacles to the broad package outlined by leaders, the range of measures agreed allow some short-term action, although there is vocal opposition from the Netherlands and Finland.
Helsinki insists that there was no agreement on bond-buying by the ESM in secondary markets at the leaders' summit.
Coordinating eurozone finance ministers has been the job of Luxembourg Prime Minister Jean-Claude Juncker since 2005, but his terms ends on July 17 and ministers are due to discuss his successor on Monday. However, confusion over who that is likely to be means his term may be extended.
Ministers will pore over the findings of the "troika" of the European Union, the ECB and International Monetary Fund from their first mission to Greece since June 17 elections.
Highlighting resistance to harsh austerity conditions imposed on Greece, Deputy Labour Minister Nikos Nikolopoulos resigned from the new government that won a parliamentary vote of confidence only on Sunday, saying it was not forceful enough in pushing lenders to ease the bailout terms. – Reuters