Spain's central government may intervene in regional finances in return for financing help as soon as next month if they do not meet the tough line needed to help allay fears over the country's debt.
Spanish 10-year government bond yields broke through the 6 per cent mark on Monday for the first time since the beginning of December. Spain has acknowledged that it has probably tipped into its second recession since 2009.
The conservative government says it is committed to making major budget cuts. But concern is growing on financial markets that the recession will make it impossible to meet deficit targets and that Spain will have to seek some kind of an international bailout, like Greece, Ireland and Portugal.
The 17 autonomous regions account for around half of public spending. They are expected to lower their own deficits to 1.5 per cent of GDP by the end of the year from 2.9 per cent.
"I wouldn't be surprised if we had to intervene as some (regions) do not have access to capital markets. So we will have to take the budget path together. The word 'intervene' sounds weighty, but they would accept the help willingly as they won't have funding on markets," the high ranking source said.
The 1970's Constitution gave the regions a lot of power over their own budgets, but their inability to rein in spending after a decade-long country-wide property boom has spooked international investors.
Regions have to present their plans to make savings of around €15-billion ($19.62-billion U.S.) in the first two weeks of May and the government could take action on plans not meeting requirements almost immediately, the source said.
On Wednesday heads of all the main regions will meet with the central government to confirm how they will meet €7-billion of savings to healthcare, and a further €3-billion to the education system.
On Monday Education Minister Jose Ignacio Wert said the cuts would mainly come from an increase in classroom sizes by up to 20 per cent and a rise in the number of teachers' working hours.
Cuts to the health system are expected to be unveiled in coming days.
Both are likely to lead to further public protests, even though a general strike on March 29 was not massively supported.
Some regions have failed to pay public service contractors for months. The Spanish central government has offered credits to help pay those debts, on the condition that regions abide by their deficit goals.
Despite rising financing costs, the source ruled out any possibility the country would need international aid.
"Markets are not being driven by the real situation in the country. Banks and the Treasury have their liquidity resolved," the source said.
Soaring bond yields raise worries the government's borrowing costs could quickly reach unaffordable levels unless the European Central Bank resumes buying government bonds in a program that has helped to keep yields down in recent months.
"We're back in full crisis mode," said Lyn Graham-Taylor, a Rabobank rate strategist. "It is looking more and more likely that Spain is going to have some form of a bailout. Assuming there is not an (ECB) intervention you would not see a cap on Spanish yields, they would just keep increasing."
Official data on total economic output in the first three months of this year is not due until April 30. However, Economy Minister Luis de Guindos said gross domestic product was likely to have fallen a similar amount to the October-December period of 2011 when the economy shrank 0.3 per cent quarter-on-quarter.
Two successive quarters of falling GDP mark a recession, which has been widely expected in Spain, but Mr. de Guindos said the downturn may not be as bad as first thought.
"At the moment I see a first quarter with a similar pattern to the last quarter of last year," Mr. de Guindos said in an interview published in El Mundo newspaper on Monday.
However, he added: "If you had asked me two months ago, I would have expected the first quarter of 2012 to be much worse than the last quarter of last year. But that's not going to be the case."
Spain's economy has been shrinking or stagnating since a property bubble burst in 2008. With house prices still sliding, the survival of some banks and the ability of the new government to control its finances are in doubt.
Lower Euribor interest rates, used to set most Spanish mortgages, had given some relief to cash-strapped consumers in a country plagued by massive unemployment, said Mr. de Guindos.
The conservatives, who won elections last November on dissatisfaction with the previous Socialist government's handling of the economic crisis, have passed a number of measures to reduce one of the euro zone's highest deficits.
However, faith in Prime Minister Mariano Rajoy's ability to work within euro zone budget limits has been tested since he unilaterally eased the 2012 deficit target at the beginning of March, prompting debt risk premiums to rise sharply.