Spanish government employees demonstrate in Madrid last week against austerity measures.
Spain denied Monday that it needed a full international bailout as the economy shrank even faster and its long-term borrowing costs jumped to dangerous highs.
The Bank of Spain said the economy contracted 0.4 percent in the second quarter, worse than the 0.3 percent of the first, citing the impact of the debt crisis on consumer spending and confidence.
On Friday, the government said the recession would continue next year, instead of end with modest growth as it had previously forecast.
The bad data compounded Madrid's pressing problems, chief among them how to cut an unprecedented unemployment rate of more than 24 percent while at the same time stabilising a stricken banking system and the public finances.
Financial markets have turned increasingly against Madrid in recent weeks after an initial positive reaction to a massive 65 billion euros austerity package turned sour, with each new initiative failing to hold the line.
In early afternoon trade, the yield -- the rate of return investors earn -- on the benchmark Spanish 10-year government bond jumped to 7.487 percent from 7.225 percent on Friday, well above the 7.0 percent danger level for long-term funding.
"There are fears that Spain is edging closer to being forced to seek a full scale bailout," said Joshua Raymond, chief market strategist at City Index traders.
Borrowing costs for other struggling eurozone states were also under pressure as the debt crisis returned with a vengeance despite an EU bank rescue deal worth up to 100 billion euros ($122 billion) for Spain which was finalized Friday.
The Italian 10-year bond yield jumped to 6.357 percent from 6.149 percent.
Any yield over 6.0 percent is widely seen as unsustainable for long-term funds, with 7.0 percent the level at which Greece, Ireland and Portugal had to ask for outside help from the EU and International Monetary Fund.
Spanish Economy Minister Luis de Guindos insisted Monday that the country did not need a full bailout but noted that the crisis appeared more than any one state could cope with.
"Spain is a solvent country and this solvability will allow us to get through the difficulties we are facing right now," the minister said.
De Guindos will hold talks with his German counterpart on Tuesday, a German government spokeswoman said, adding that Berlin had "no information" that Spain was poised to make an application for a full-blown state bailout.
News on Friday that the Valencia region was to ask the central government for financial aid raised the prospect that Madrid will face greater calls on its resources from provincial governments at a time when it is strapped for cash.
Spain last year missed its public deficit target of 6.0 percent of economic output by a wide margin, coming in instead at 8.9 percent, with the 17 regional governments, which fund education and health, largely blamed for the blowout.
Spain's market regulator on Monday banned the short-selling of financial stocks for three months, as the bourse tumbled.
"The situation of extreme volatility across the European markets could interfere with their smooth functioning and the normal course of their activities," the CNMV regulator said in a statement.
The CNMV said the decision was taken "so as to maintain financial stability," with the ban running until October 23.
European stockmarkets also fell sharply Monday, with Madrid down around 3.0 percent in mid-afternoon having shed as much as 5 percent in the wake of a near 6 percent plunge on Friday.
London fell 1.73 percent, Paris was down 2.05 percent and Frankfurt shed 1.70 percent while inNew York the Dow Jones Industrial Average tumbled 1.67 percent in the first five minutes of trade.
The Spanish government recently announced massive spending cuts and other measures to stabilise its public finances but the austerity program seems only to have driven speculation that Madrid may need a full EU-IMF bailout.
Since the Spanish economy is much larger than those of Greece, Ireland and Portugal combined, there are growing raised concerns that EU rescue mechanisms might not be enough to cope, especially if Italy has problems too.
"Investors fear that the eurozone's fourth largest economy is soon to follow Greece, Ireland, and Portugal in requesting emergency funding, with yields on ten-year debt fast approaching 7.5 percent," said Spreadex trader David White.
The euro was similarly losing ground, trading near two-year lows at $1.2128, down from $1.2152 in New York late Friday.
To add to the tensions on the markets, Greece moved centre stage as EU and IMF officials readied for a review this week which will determine whether Athens gets another cash injection to keep it afloat beyond the summer.
Their report will determine whether Greece will receive fresh loans of 31.5 billion euros ($38 billion) by September under its debt rescue program.
German Finance Minister Wolfgang Schaeuble warned Greece in a newspaper interview Monday that it must redouble efforts to comply with bailout conditions imposed by international creditors.