Spain fears drive investors to safe havens
Concerns over Spain's financial situation have sparked losses for shares across Europe and the United States.
Investors have moved into safe haven investments, including US and German government bonds.
Meanwhile the indicative cost of borrowing for Spain soared as investors worried about its deficit.
The European Commission also said that Spain could be given extra time to meet an agreed EU deficit target.
The EU's economic affairs commissioner, Olli Rehn, said: "We are ready to consider proposing an extension of the deadline to correct the excessive deficit by one year to 2014," as long as Spain reined in deficits in self-governing regions and presented a "solid" two-year budget.
He said the EU would present a more thorough assessment over the course of the coming weeks.
Concerns over Spain's financial situation drove up the yield on the government's 10-year bonds to 6.7%.
Yields reflect how much investors demand in return for holding a bond, with a higher yield an indication of the perceived risk.
It is also an indication of how much a government has to pay to borrow money on the international money markets.
Investors moved money into US and German government bonds which are considered to be safe havens.
That drove the yield on 10-year US Treasury bonds to a record low of 1.64%. The yield on German government 10-year bonds fell to 1.283%.
Under EU rules, Spain needs to reduce its fiscal deficit from 8.9% of GDP, or economic output, to 3% by 2013.
As part of its second annual economic health check of European Union members, the European Commission said Spain needed further reforms in order to achieve it.
It says Spain's economy will shrink by 1.8% this year and 0.3% next with the unemployment rate hitting 25.1% in 2013.
The commission said Spain had taken steps to improve its position and had recently adopted ambitious reforms, including key areas such as the financial sector and the labour market, but it added that the country continued to face problems.
"Spain continues to face important policy challenges following the bursting of the housing and credit bubble. Further fiscal consolidation and fiscal discipline at regional level are necessary to restore market confidence and to halt the rapid increase in government debt," it said.
The commission has also suggested that what Europe needs is a "banking union", which the BBC's business editor Robert Peston said would involve centralised supervision of eurozone banks and possibly even compensation schemes across the eurozone.
It also suggested the idea of bailouts for ailing banks directly from a eurozone rescue fund rather than helping national governments - something that Spain's prime minister was pushing last week.
Share markets in Europe and the US were between 1-2.5% lower on Wednesday.
The Dow Jones index closed almost 1.3% lower.
The euro hit its lowest rate against the US dollar for two years, falling to $1.2382.
Tensions over eurozone debt also forced the Italian government into paying sharply higher rates on Wednesday to borrow 5.7bn euros ($7.2bn; £4.6bn) from the markets.
To borrow over five years, it had to pay 5.66%, compared with the 4.86% it paid in an auction in April.
A rate consistently above 7% is considered to be unsustainably high and an indication that markets think a country will be unable to pay its debts; Greece, Portugal and the Republic of Ireland were at that level when they received international bailouts.
Spain's economy has become the focus of investor concern due to the uncertainty surrounding the fate of its banking system.
On Friday, Spanish banking group Bankia, which was formed from the merger of several struggling regional lenders, asked for a 19bn-euro bailout, a much larger amount than had been expected.
But it is not yet clear how the Spanish government will raise the much-needed funds.
Reports suggested that with borrowing costs rising towards unsustainably high levels, the government may instead give Bankia bonds, which Bankia can then use as collateral to borrow from the European Central Bank (ECB).
Both sides have refused to confirm reports of the plan, with the ECB denying on Wednesday that it had vetoed the idea.
"Contrary to media reports published today, the European Central Bank has not been consulted and has not expressed a position on plans by the Spanish authorities to recapitalise a major Spanish bank," it said in a statement.
"The ECB stands ready to give advice on the development of such plans," it added.
Spain's property boom and bust has left its banking sector very weak, and with unemployment among the highest in the eurozone the country is struggling to raise enough in taxes to fund spending.
The Bank of Spain's governor, Miguel Angel Fernandez Ordonez, said that the Spanish government's estimates for tax income this year could fall short and spending could be higher than expected.
The governor, who said he would resign a month earlier than scheduled, said if the government's deficit-cutting plans went off course this year it should bring forward a rise in VAT which is planned for 2013.