European policymakers sought to quash talk of a euro zone rescue for Spain on Tuesday as the country's borrowing costs rose further in a debt auction ahead of an EU summit to discuss steps to fix the currency bloc.
A German government official said he did not think Spain, which was forced to deny reports it may soon require a Greek-style bailout, would be on the agenda of the summit to discuss stricter fiscal rules and economic reform on Thursday.
Germany's ZEW economic sentiment indicator suffered its biggest monthly drop since the height of the financial crisis in October 2008 — right after the collapse of Lehman Brothers — partly due to rumors about debt problems in Spain.
Chairman of euro zone finance ministers, Jean-Claude Juncker, said Spain's economic fundamentals were different from Greece's.
"Financial markets shouldn't make the mistake of establishing an equivalence between Greece and Spain," Juncker told Reuters on a state visit to Norway.
Markets would one day be convinced euro zone states were doing the right things to deal with the debt crisis, he said.
International Monetary Fund chief Dominique Strauss-Kahn will visit Madrid on Friday, after the EU summit, for talks with Prime Minister Jose Luis Rodriguez Zapataero on Spain's economic policies and reforms, an IMF spokeswoman said.
A day after admitting that some Spanish banks were being frozen out of international credit markets, Madrid raised 5.2 billion euros ($6.37 billion) in 12- and 18-month T-bills at an auction, but paid a significantly higher average yield than last month.
The euro and European stocks rallied after the auction reassured investors that Spain was in no immediate financial danger and will be able to meet a 16.2 billion euro debt redemption due by the end of July.
"This was another test, which they passed with flying colors," said Eric Wand of consultancy 4Cast. "It's costing more, but still at a vaguely palatable level.
The 12-month bill, which paid an average yield of 2.303 percent after 1.59 percent in the same auction in May, and the 18-month, which gave 2.837 percent, up from 1.951 percent, were seen as litmus tests for a more important 10- and 30-year bond auction on Thursday.
However, Marc Ostwald, bond strategist at Monument Securities in London, said the fact that Spain had paid far more than France called into question its top-notch rating from agencies such as Moody's Investor Service.
Moody's shocked markets on Monday by abruptly downgrading Greece's sovereign debt by four notches to junk status.
EU Economic and Monetary Affairs Commissioner Olli Rehn told the European Parliament the timing of Moody's decision was "astonishing and unfortunate," saying it had not taken into account latest developments in the country.
The downgrade may force investors to sell billions of euros of Greek government bonds after Barclays Capital and Citigroup strip them from indices that determine the composition of index-tracking funds.
The European Central Bank said it had started applying a 5 percent penalty, known as a "haircut," when accepting Greek bonds as collateral in lending operations due to the Moody's rating change. That means commercial banks will receive less money in exchange for Greek bonds than if they tendered government bonds of another euro zone nation as a security.
Another credit watchdog agency, Fitch Ratings, said financial markets had overreacted to the euro area's sovereign debt problems, though traders were likely to keep testing the region's commitment to the single currency.
Fitch analyst Brian Coulton told reporters his agency had no plans to follow Moody's in downgrading Greek debt to junk.
Ahead of Thursday's EU summit, French President Nicolas Sarkozy bowed to German demands for tougher European budget rules and dropped his call for a separate "economic government" of the 16-nation euro zone with a dedicated secretariat.
After talks in Berlin on Monday, Sarkozy accepted a German proposal that euro zone states which persistently breach budget deficit limits should have their voting rights in the bloc suspended, even if that requires changing the EU treaty.
He also yielded to Chancellor Angela Merkel's insistence that closer "economic government" should involve all 27 European Union members and not just those that share the common currency.
Amid persistent worries about the solvency of European banks, the Spanish daily El Pais quoted government sources as saying Madrid wants EU regulators to publish the results of stress tests of individual banks to restore confidence. The Spanish Banking Association said the stress test results should be made public.
There was no comment from the government or the Bank of Spain, but a German official told reporters that publishing the data was a possibility among several options.
Germany, France and the European Central Bank have so far opposed such a move, advocated forcefully by U.S. Treasury Secretary Timothy Geithner, because they fear it could trigger more speculation against European banks.
Economists say Europe could face prolonged economic stagnation with "zombie banks," as Japan did in the 1990s, unless governments act decisively to force banks to resolve bad debts and recapitalize, merge or shut down those in trouble.
France and Spain are both due to announce major structural economic reforms on Wednesday.
An overhaul of France's generous pay-as-you-go pension system is expected to raise the legal retirement age from 60 to 62 or 63, extend the contribution period for a full pension and introduce extra levies on higher earners.
Spain's minority Socialist government, fighting a 20 percent unemployment rate, is seeking opposition support for a major shake-up of the country's rigid labor market to make it easier and cheaper to hire and fire. Unions called a general strike for Sept. 29 in protest.
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