Spain is in the gravest danger since the end of the Franco dictatorship as it is frozen out of capital markets and slides towards a showdown with Europe."We're in a situation of total emergency, the worst crisis we have ever lived through" said ex-premier Felipe Gonzalez, the country's elder statesman.The warning came as yields on Spanish 10-year bonds spiked to 6.7%, pushing the "risk premium" over German Bunds to a post-euro high of 540 basis points.The IBEX index of stocks in Madrid fell 2.6%, the lowest level since the dotcom bust in 2003.Chaos over the euros 23.5bn (£18.8bn) rescue of crippled lender Bankia led to the abrupt resignation of central bank governor Miguel Angel Fernandez Ordonez, who testified to the senate that he had been muzzled to avoid enflaming events as confidence in the country drains away.Markets are on tenterhooks as Spanish yields test levels that forced the European Central Bank to respond last November with its euros 1 trillion liquidity blitz."Nobody is short Spanish debt right now because they are expecting ECB intervention," said Andrew Roberts, credit chief at RBS. "If it doesn't come - if we take out 6.8% - we're going to see a hyperbolic sell-off."Italy felt the full brunt of contagion from Spain, with 10-year yields back near 6%.The euro fell to a 2-year low of $1.239 against the dollar. Crude oil and metal prices plummeted and safe-haven flight pushed rates on two-year German debt to zero. Gilt yields fell to 1.64%, the lowest in history.Roberts said the collapse in Spanish tax revenues is replicating the pattern in Greece. Fiscal revenues have fallen 4.85 over the past year and VAT returns have slumped 14.6%. Debt service costs have risen by 18%.The country is caught in a classic deflationary vice: a rising debt burden on a shrinking economic base."Once you get into such a negative feedback loop, you can move beyond the point of no return quickly," Roberts said.The European Commission - which yesterday issued a downbeat report on the region's economic health - has softened its stance, giving Madrid an extra year until 2014 to cut its budget deficit from 8.9% to 3% of GDP, though this still amounts to a fiscal shock.Brussels told premier Mariano Rajoy to widen the VAT base and speed the increase in the retirement age.There is no sign so far that the ECB is ready to relent as Frankfurt and Madrid cross swords in an escalating test of will. The ECB has scotched Mr Rajoy's tentative plans to recapitalise Bankia by drawing on ECB funds."It is dangerous to play chicken when you are driving a Seat and the ECB is driving a tank," said professor Luis Garicano from the London School of Economics.Mr Garicano said Madrid has overplayed its hand but the ECB needs to be careful, too, since Spain is increasingly tempted by the example of Argentina, which recovered quickly after leaving its dollar-peg."The Rajoy people will do anything to avoid the slow agony of Greece," he said. "There is massive disaffection with the euro in Spain and papers like El Pais and Vanguardia are turning anti-German."The latest PEW survey shows that just 37% of Spaniards think the euro has been good for the country. Most still want to stay in the union but the number is falling fast. The survey found that 40% of Italians want to return to the lira.The ECB is pushing Spain to accept a loan package from the EU bail-out fund (EFSF), the proper body for fiscal rescues. Mr Rajoy has refused vehemently. Any recourse to the EFSF is viewed with horror in Madrid, entailing an unacceptable loss of sovereignty.The result is paralysis as both sides refuse to shift ground.Rajoy is clinging to hope that the EU will take care of Spain's banks through an EMU-wide recapitalisation plan. This would avoid stigma and draconian conditions.Brussels floated the idea yesterday (Wednesday) for a eurozone "bank union" and use of the European Stability Mechanism - which has not yet been ratified by most states - to rescue banks and sever the dangerous nexus between crippled lenders and crippled states.The proposals were shot down instantly by Berlin. Such plans amount to debt-mutualisation, a form of back-door eurobonds. German opposition is "well known", said Berlin.Sources in Berlin say Germany wants Spain to tap the International Monetary Fund - as well as the EU - to spread the rescue burden to the US, China, Japan, Britain and others.Professor Paul De Grauwe of the LSE accused the ECB of cherry-picking treaty clauses to justify inaction and failing to carry out its crucial mandate of financial stability."They should buy Spanish and Italian bonds to cap yields at 300 basis points over Bunds, and let the lawyers argue about it for the next 10 years," he said.Eurozone data released yesterday show that private credit and all key measures of the money supply contracted in April, suggesting that the ECB's euros 1 trillion liquidity blitz over the winter has failed to gain traction.Guy Mandy, credit strategist at Nomura, said the ECB has lost sight of the big picture and risks losing the euro altogether if if fails to restore basic confidence. "They need to weigh up events on a grander scale, stop worrying about moral hazard and do the job of a central bank," he said.The Daily Telegraph302030 GMT May12 

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