BRUSSELS/MADRID (Reuters) - The European Commission threw Spain, the latest frontline in Europe's debt war, two potential lifelines on Wednesday, offering more time to reduce its budget deficit and direct aid from a euro zone rescue fund to recapitalise distressed banks.
Spanish government borrowing costs lurched higher and the Madrid stock market hit a nine-year low with investors rattled by the parlous state of its banking sector fleeing to the relative haven of German bonds.
EU Economic and Monetary Affairs Commissioner Olli Rehn said Brussels was ready to give Spain an extra year until 2014 to bring its deficit down to the EU limit of 3 percent of gross domestic product if Madrid presents a solid two-year budget plan for 2013-14, something it has committed to do.
The concession, which Madrid has not publicly requested, was on condition that Spain effectively reins in overspending by its autonomous regions, makes further financial sector reforms and recapitalises its troubled banks.
While the Commission is responsible for proposing laws, it is member states that decide whether to adopt them.
EU paymaster Germany has so far firmly opposed any collective European banking resolution and guarantee system or any use of bailout funds without a country having to submit to a politically humiliating EU/IMF austerity programme.
Rehn said there were no grounds for giving Italy a similar extension to balance its budget, due in 2013, since unlike Spain its economy is forecast to start growing again next year.
In an economic policy document which laid out some of the dramatic policy proposals which analysts say are needed to tackle the debt crisis, the European Union's executive arm said the vicious circle of weak banks and heavily indebted states lending to each other must be broken and called for a banking union in the euro zone.
Commission President Jose Manuel Barroso said tighter euro zone integration could include a joint bank deposit guarantee scheme to prevent a bank run and euro area financial supervision, saying the mood had changed since member states unanimously rejected a joint deposit guarantee fund only months ago.
"In the same vein, to sever the link between banks and the sovereigns, direct recapitalisation by the ESM (European Stability Mechanism) might be envisaged," the report said.
Permitting the ESM to lend directly to banks would require a change to a treaty in the midst of ratification by member states that might come too late for Spain's needs. Spanish premier Mariano Rajoy backs the idea but Rehn appeared cool to it.
"Direct disbursements to banks are not foreseen as such in the treaty, and therefore this is not an available option ... in terms of direct recapitalisation," Rehn told reporters.
Spain's banking woes - the result of a burst property bubble aggravated by recession - have combined with growing uncertainty about Greece's survival in the euro zone to reignite Europe's sovereign debt crisis. That drove the euro to a two-year low below $1.2450, while European shares also fell after Italy had to pay heavily to sell bonds.
Madrid said its bank rescue fund would issue bonds to inject funds into nationalised lender Bankia, but that looks expensive with 10-year borrowing costs at 6.65 percent near their euro era peak and close to levels at which Ireland and Greece were forced to seek international bail-outs.
Investors unnerved by Spain's deepening financial crunch pushed Italy's funding costs sharply higher at a bond sale, with 10-year yields topping 6 percent for the first time since January.
In a sign of heightened anxiety in Washington, top U.S. Treasury official Lael Brainard was despatched to hold talks in Greece, Germany, Spain and France "to discuss their plans for achieving economic stability and growth in Europe", the Treasury Department said.
Barroso said Europe's G8 partners, at a summit in the United States 10 days ago, had asked the euro zone to go further with financial and economic integration.
A sudden economic deterioration in Europe would pose a serious threat to the U.S. economy and hence to President Barack Obama's re-election prospects in November.
Rajoy has insisted his government has no intention of seeking an EU/IMF bailout either for its banks or for the state.
But the abrupt resignation of Bank of Spain Governor Miguel Angel Fernandez Ordonez on Tuesday, a month before his term was due to end, added to doubts about the handling of the Bankia crisis and relations with European institutions.
Highlighting Spain's difficulty in meeting fiscal targets while gripped by a deep recession, the outgoing central bank chief said tax revenue may fall short of government estimates and spending may be higher than expected.
He recommended bringing forward a rise in value-added tax set for 2013 if the deficit objective goes off track this year.
In its country report on Spain, the Commission said the latest banking reform presented this month did not go far enough and needed to be strengthened to include provisioning on mortgages and lending to small businesses.
It also warned that unless policies are changed, Spain's debt will spiral to 100 pct of GDP by 2020. Madrid had one of the lowest debt ratios in the euro zone before the crisis at about 35 percent of GDP.
Less than three weeks before a crucial second general election that may determine whether Greece stays in the 17-nation currency area, Greeks were warned by their biggest bank that they face economic catastrophe if they leave the euro.
Living standards would plummet, incomes would be slashed by more than half, and inflation and unemployment would skyrocket, the National Bank of Greece said.
The outcome of the election was thrown into doubt on Wednesday when a poll suggested the anti-bailout SYRIZA party would win, contradicting six previous forecasts.
The worries about Spain and Greece have hit efforts by other trouble euro zone countries to emerge from their own debt woes.
The Irish vote in a referendum on a European budget discipline treaty on Thursday which is seen as a precondition for receiving further EU/IMF aid.
Opinion polls forecast a solid win for the "Yes" camp, but Ireland's hopes of returning to bond markets late next year as a reward for textbook implementation of an austerity programme have been clouded by wider uncertainty in the euro zone.
Safe-haven German bond yields hit a record low as worries about Spanish banks intensified while Spain's benchmark IBEX stock index, which is down 28 percent this year, fell 2 percent after hitting a new nine-year low earlier in the session.
Additional reporting by Robert Hetz, Nigel Davies and Carlos Ruano in Madrid, George Georgiopoulos in Athens, Jan Strupczewski in Brussels; Writing by Paul Taylor, editing by Mike Peacock and Janet McBride