European Central Bank President Mario Draghi quashed talk of anearly exit from emergency stimulus measures as Spain struggled toborrow in financial markets, a reminder of the risk that theregion's debt crisis could flare again.

Speaking just hours after Spanish Prime Minister Mariano Rajoywarned his country faces “extreme difficulty,” Draghi said talk ofthe ECB starting to withdraw its support for euro-area banks is“premature.” At the same time, in a nod to growing inflationconcerns in Germany, Draghi said the ECB won't hesitate to counterupside price risks if needed. Policy makers left their benchmarkrate at a record low of 1 percent today.

The ECB has expanded its balance sheet by about 30 percent sinceDraghi took office in November, pumping more than 1 trillion euros($1.3 trillion) into the banking system in a bid to stem the debtcrisis. Pressure to unwind the emergency measures is rising inGermany, where workers are winning some of the biggest payincreases in two decades, threatening to stoke inflation.

“Premature Bundesbank calls for an ECB exit strategy have nowtriggered a new round of market wobbles, with a focus on Spain,”said Holger Schmieding, chief economist at Berenberg Bank inLondon. “The risk of a new irrational market panic remainsserious.”

While the ECB's three-year loans to banks have helped easetensions on financial markets, lowering borrowing costs fordebt-strapped governments, bond yields are rising again inSpain.

The euro area's fourth-largest economy sold 2.59 billion eurosof bonds today, just covering the minimum amount targeted. Afterthe auction, yields on the country's ten-year bonds surged to morethan 5.6 percent, the highest in three months.

“Spain is facing an economic situation of extreme difficulty, Irepeat, of extreme difficulty, and anyone who doesn't understandthat is fooling themselves,” Rajoy told a meeting of his People'sParty as he seeks to push through the deepest budget cuts in threedecades.

Declining to comment directly on the Spanish auction, Draghisaid governments must make use of the window of opportunity createdby the ECB's emergency measures to deliver on promised structuralreforms and fiscal consolidation.

Exit Pressure

Draghi faces pressure from some ECB policy makers to startplanning an exit as higher energy costs keep euro-area inflationabove the central bank's 2 percent limit and price pressures brewin Germany.

Two million public service workers in Europe's largest economywill get a pay increase of 6.3 percent by the end of next yearunder a deal struck with the government, according to the Ver.diunion. IG Metall, Europe's biggest labor union with about 3.6million workers, is demanding 6.5 percent more pay.

The ECB hardened its tone on inflation in today's policystatement, saying “all the necessary tools are available to addressupside risks to price stability in a firm and timely manner” andthat it will pay “particular attention to any signs of pass-throughfrom energy prices to wages.”

Still, Draghi said the economic outlook is subject to downsiderisks and inflation will remain contained in the medium term.

“The combination of inflation and sovereign debt risksessentially leave the ECB stuck between a rock and a hard place,”said Nick Kounis, head of macro research at ABN Amro in Amsterdam.“The central bank is likely to keep interest rates and non-standardmeasures unchanged for the foreseeable future.”

Widening economic divergences in the 17-nation euro area and thethreat of the debt crisis intensifying again make it harder for theECB to set its “one-size-fits-all” policy.

The European Commission forecasts growth of 0.6 percent inGermany this year and contractions in Italy, Spain, Belgium,Greece, Cyprus, the Netherlands, Portugal and Slovenia. Theeuro-area economy is projected to shrink 0.3 percent.

“Single monetary policy naturally focuses on maintainingmedium-term price stability for the euro area as a whole,” Draghisaid. “It is up to national policy makers to foster domesticdevelopments which support the competitiveness of theireconomies.”

Spain is struggling with unemployment in excess of 23 percentand a budget deficit that hasn't been under the European Union's 3percent limit since 2007. Investors began to doubt the country'sability to carry a debt load of nearly 80 percent of gross domesticproduct last year after the debt crisis spread beyond Greece.

In defending budget reductions worth more than 27 billion eurosto cut 3.2 percent from the national deficit, Rajoy raised thespecter of an international bailout that would see Spain joinGreece, Ireland and Portugal in needing EU and InternationalMonetary Fund aid.

“We remain concerned about the risk of another bout of financialmarket tensions linked to the debt crisis, and note the troublingrise in bond spreads in both Italy and Spain in recent weeks as apotential early sign of re-emergence of market stress,” said SimonBarry, chief economist at Ulster Bank in Dublin. “On balance, wethink that if there is to be a move in ECB interest rates thisyear, it's more likely to be a cut rather than a hike.”

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