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The euro zone must boost growth and cut debt to regain investor confidence but it should also move towards a banking union, consider eurobonds and the direct recapitalization of banks from its permanent bailout fund, the European Commission said on Wednesday as it laid out year-long recommendations.
In documents outlining the economic strategy for the euro zone, the Commission directly addressed market concerns about problems in the Spanish banking sector and the cost to the Spanish government of rescuing it - a factor that has driven Spain's borrowing costs to near unsustainable levels.
Investors worry that public finances in Spain, which is already struggling to cut it large budget deficit at a time of recession, will become unsustainable if it is forced to bail out is banks, after a real-estate market boom turned to collapse and left nearly all banks laden with bad property loans.
The Commission, the European Union's executive, said the vicious circle of weak banks and indebted sovereigns lending to each other needed be broken.
"A closer integration among the euro area countries in supervisory structures and practices, in cross-border crisis management and burden sharing, towards a "banking union", would be an important complement to the current structure" of Europe's economic and monetary union, the Commission said.
"In the same vein, to sever the link between banks and the sovereigns, direct recapitalization by the ESM might be envisaged," the document said.
The euro zone's permanent bailout fund, the European Stability Mechanism (ESM), which comes into force in July, cannot as it stands lend directly to banks, only to sovereigns, even if only for the specific purpose of bank recapitalization.
To change that, euro zone countries would have to change the treaty on which the ESM is based and which some euro zone countries have already ratified. Time is running short to do that, especially with the rapidly mounting problems in Spain.
Germany also strongly opposes allowing the ESM to directly recapitalize banks -- an option Spain wants.
In a separate assessment of Spanish fiscal and reform plans, the Commission said that while Madrid has done much to help its banks, it had to tackle the remaining financial sector weakness.
"Recent reforms have helped to speed up restructuring of the banking sector, which should continue. However, ensuring the stability of the financial sector is still a challenge," the Commission said. "Given the risk of bank-funding stress, it is necessary to continue to strengthen the banks' capital base."
"The reform measures adopted in February and May 2012 targeted the legacy stock of real estate assets, but the vulnerabilities related to other exposures such as loans to SMEs and residential mortgages have not been addressed," it said.
"Spain needs to ensure that the policy response is consistent with a broader strategic context (i.e. on-going discussions about new proposals for recapitalizing of the financial sector across the euro area)," it said.
The Commission said Spain could try to raise additional revenues by getting more money from valued added tax, reducing tax breaks and raising excise duties on fuel. It has to cut spending on health care and pensions, among other areas.