Cyprus Sell-Off Sparks Fears of Crunch Time for Spain

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Spain's banking bailout last year is now a distant memory. First Italy, then Cyprus refocused the market's attention away from Madrid, but according to one strategist, Spain's fragile economy now faces the possibility of tipping over into a renewed credit crunch.

Markets dipped slightly in the last two weeks as Cyprus agreed to a 10 billion euro ($13 billion) bailout from the so-called Troika. Banking stocks on the pan-European FTSEurofirst 300 Index, which had a strong start to the trading year, were hit the hardest, sinking around 7 percent since mid-March.

This could have serious repercussions in Spain, Stephane Deo, global head of asset allocation at UBS told CNBC, adding that Spanish banks will find it hard to refinance as investors "price-in" the risk. That in turn will hit lending to businesses and could create a credit squeeze.

(Read More: Spain to Revise Down 2013 GDP Growth Target to -1 Percent)

"This is obviously a problem. I think Spain has a lot of wholesale funding to do, if you put more risk into the funding, obviously the price will be higher and higher," he told CNBC Thursday. "So that again will feed into the credit crunch."

Financing for European banks, especially those in Spain will be much more difficult as the country also tries to cut government spending, he said, adding that the European Central Bank needs to address the situation.

"When you do fiscal reckoning...and you have a credit crunch at the same time, you're economy is affected very badly and the impact of your fiscal tightening is not that big," Deo said.

(Read More: Reasons to Believe Spain's Recovery Is Not Far Away)

On Thursday, Mario Draghi, president of the European Central Bank reiterated that the ECB could not compensate for the lack of capital in Europe's banking system. That led to a decline in banking stocks.

Meanwhile, Spain is likely to revise down its economic growth forecast for 2013 next week, a government source told the Reuters news agency earlier this week. The Spanish government also plans to ask the European Union for more time to allow it to reduce its budget deficit, the source said.

Gross domestic product (GDP) could contract by 1 percent rather than 0.5 percent in 2013, the source told Reuters, and the deficit target for this year could extend to 6 percent of GDP, rather than the proposed 4.5 percent.

Thursday's data wasn't much better for Spain with purchasing managers' index (PMI) for the services sector showing a contraction for the 21st month in a row.

(Read More: Bank of Spain: Economy to Sink Deeper Into Recession)

Government debt however continues to see strong demand. The Spanish treasury raised $5.52 billion at an auction on Thursday, above the offer size. Spain's benchmark 10-year bond yield fell slightly on the news dipping by 4 basis points to 4.87 percent.

Even during the height of the Cyprus sell-off, yields on Spain's 10-year sovereign debt, so often used to gauge the euro zone crisis in the past, remained relatively stable, hovering around the 5 percent level.

"The resilience of Spain's government bond market is nothing less than remarkable given the country's dire fundamentals and the precedent-setting bail-in of private creditors in Cyprus," Nicholas Spiro, managing director at Spiro Sovereign Strategy said in a research note.

"The disconnect between Spain's bond market and the real economy is growing, raising the stakes for Spain should sentiment towards the euro zone deteriorate in the second quarter," he said.

By's Matt Clinch