European stocks and the euro slumped on Tuesday and German bonds hit a record high as investors worried about the fate of euro zone banks and the impact of austerity measures on economic growth.

Highly indebted Italy was the latest euro zone country due to announce a three-year austerity plan worth 24 billion euros later on Tuesday. Partly in anticipation of those measures, Italian consumer confidence fell to a one-year low in May, below analysts' forecasts, the ISAE research institute said.

The pan-European stock index fell 2.8 percent to its lowest level since early September, led lower by banking stocks, when trading resumed in most of continental Europe after the Whitsun long weekend, during which the Bank of Spain took over a small savings bank, CajaSur.

The bailout was likely just the first of several rescues of small lenders in Spain but analysts there underlined these have long been planned and are part of efforts to rationalize the sector rather than a threat to its financial stability.

Markets remain in nervous form, however, worried that more troubles in southern Europe will have knock on effects for larger euro zone banks, who are owed billions by public and private borrowers in the region.

The dollar, seen as safe haven from Europe's debt worries, gained 1 percent against euro and sterling.

Shares in Europe and Asia were also dragged lower by fears that austerity measures being announced by European governments that went heavily into debt and deficit during the financial crisis will shackle a global economic recovery.

Households are bracing themselves for painful austerity measures as the sovereign debt crisis in Greece has resulted in sharper focus on Italy's high public debt level, said Raj Badiani of IHS Global Insight.

CUT TOO FAST

The global financial system is showing signs of increased stress, though still well short of the panic that followed the collapse of investment bank Lehman Brothers in September 2008.

The two-year U.S. bond-swap spread, a key gauge of financial system stress, rose to fresh one year highs near 60 basis points, up from 51 bps on Monday. It reached 160 bps in the weeks after the Lehman crash.

There is indeed a risk that, under market pressure, some countries overdo austerity, Olivier Blanchard, chief economist of the International Monetary Fund, said in a newspaper interview. That would be a mistake.

Markets tend to lump a series of countries in the same basket. In fact, other European countries don't need to take the same draconian measures as Greece to reduce their budget deficits, Blanchard told French business daily La Tribune.

They are more credible to start with, with less debt, and they can afford a more gradual adjustment to limit the negative impact of consolidation on short-term growth.

DEEP-ROOTED

A month-long selloff has routed global stocks as even a $1 trillion pledge from European leaders was not enough to calm fears that Greece's debt woes would spread to other deeply indebted nations, particularly in southern Europe.

Japan's Nikkei average slid 3 percent to its lowest since December 2009, taking losses since the start of April to about 17 percent, while stocks elsewhere in the Asia-Pacific region tumbled 3.6 percent.

Concern at increasingly fierce rhetoric between North and South Korea over the sinking of a South Korean warship added to stock market nerves in Asia.

The euro problems are very deep-rooted as euro zone members share a common currency but fiscal policies are left to each country, Japanese Finance Minister Naoto Kan told reporters. I hope financial markets will calm down gradually.

Kan's comments added to a chorus of voices expressing concern about the impact of Europe's debt troubles on a global economy still struggling to recover after the implosion of the U.S. mortgage market sparked the financial crisis in 2008.

White House economic adviser Lawrence Summers also listed Europe's struggle to contain Greece's debt crisis as one several potential troubles facing the U.S. economy.

Investors have started to sell the euro, believing that there'll be more banks in trouble, particularly in Southern Europe, said a currency trader at a European bank. The euro's fall has not run its course.

The IMF's Blanchard said markets will remain concerned until doubts over the EU delivering promised loans for the Greek government and Greece's debt-payment history are resolved.

The markets are wondering if Greece will be able to repay its debt or not, he said. Given the behavior of Greek governments in the past their uncertainties are understandable.

(additional reporting by Tetsushi Kajimoto in Japan, Ian Chua and Carolyn Cohn in London; writing by Paul Taylor, editing by Patrick Graham)

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