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MADRID/ATHENS (Reuters) - Spain lurched closer to becoming the largest euro zone country yet to be shut out of credit markets when it had to pay a euro era record price to sell short-term debt on Tuesday.
The soaring borrowing costs showed that a euro zone deal to lend Spain up to 100 billion euros ($126 billion) for its banks had not solved the country's problems or restored investor confidence and suggests more aid may be needed fix its finances.
They also illustrated how Europe's troubles run much deeper than Greece, brought back from the brink of default by Sunday's parliamentary election that has cleared the way for a renegotiation of the terms of its bailout package.
The two-and-a-half year old debt crisis has hobbled the global economy and world leaders meeting in Mexico piled pressure on the euro zone to move towards a fiscal and banking union to fix the crisis that now threatens to engulf Spain.
"The decidedly elevated yield levels leave a question mark firmly in place as regards the sustainability of Spain's public finances while doing nothing to temper speculation as to how long the country might hold out before looking for a more comprehensive bailout," said Rabobank strategist Richard McGuire.
Spain, the euro zone's fourth largest economy, had to pay 5.07 percent to sell 12-month Treasury bills and 5.11 percent to sell 18-month paper - an increase of about 200 basis points on the last auction for the same maturities a month ago. Yields on longer-term bonds are over 7 percent.
The auction underscored the government's increasingly shrill pleas for help from the European Central Bank, two days before Madrid tries to sell three-to-five year bonds.
The ECB believes it can have little lasting influence on market confidence unless euro zone political leaders take bold decisions to strengthen the 17-nation currency zone although President Mario Draghi has hinted at a rate cut.
The central bank, the only federal institution with the capacity to act swiftly and decisively, is also split between hawks and doves, with German-led hardliners publicly opposing further purchases of government bonds of debt-stricken nations.
Germany, Europe's biggest economy and paymaster, has taken a tough line with countries in trouble during the crisis.
But its own economic outlook is darkening with the closely-watched ZEW index of analyst and investor sentiment falling at its fastest rate since October 1998, before the euro was launched.
German Chancellor Angela Merkel, attending the meeting in Mexico, agreed to move towards a more integrated European banking system, according to a draft G20 communique, but she continues to rule out mutualising the euro zone's debts.
Speaking to reporters on the sidelines of the G20 summit, Spanish Economy Minister Luis de Guindos said Madrid's policies were not to blame for the loss of investor confidence.
"We think ... that the way markets are penalizing Spain today does not reflect the efforts we have made or the growth potential of the economy," he said. "Spain is a solvent country and a country which has a capacity to grow."
Some market experts said the strong demand at Tuesday's T-bill auction reflected expectations that Spain would be able to avoid a full state bailout of the kind international lenders have provided for Greece, Ireland and Portugal.
"It's in no one's interest to see Spain bailed out, because then there will be questions as to whether there are enough funds, and questions over Italy," said one market maker in Spanish bonds.
Others voiced doubt that Spain, a proud, ancient nation that was a fast-growing star of the euro zone for a decade until a housing bubble burst in 2008, could avoid a sovereign rescue.
Standard & Poor's head of EMEA sovereign ratings, Moritz Kraemer, told Reuters television that an aid program was not necessarily a bad thing and was already factored into Spain's current BBB+ rating.
Spain's problems are already having an impact elsewhere. French food group Danone warned of a hit to its profits this year, partly because Spanish consumers have switched to cheaper yoghurts.
The euro zone debt crisis started in 2009 in Greece where mainstream, mainstream political leaders are racing to build a coalition government led by conservative New Democracy leader Antonis Samaras after a weekend election.
He has said he wants extra time to meet the conditions of the 130 billion euro EU/IMF bailout agreement.
A senior euro zone official said the terms of the deal would be renegotiated because the May and June elections had delayed implementation of the program, knocking the targets off track.
"Because the economic situation has changed, the situation of tax receipts has changed, the rhythm of the implementation of the milestones has changed, the rhythm of privatization has changed -- if we were not to change the MoU (memo of understanding) -- it does not work," the official said.
But a gap yawned between the ambitious objectives for more time and easier conditions of the Greek pro-bailout parties and the willingness of European partners to make minor adjustments to the austerity and reform package.
Samaras has said he wants two extra years to bring Greece's public deficit down to the EU limit of 3 percent of GDP by 2016 instead of 2014, spreading out 11.7 billion euros of spending cuts due next month over the next 18 months.
The senior euro zone official in Brussels said that while details of the bailout were "changeable" and could be adapted, the drive to bring Greek debt down to a manageable level and push through structural economic reforms would not weaken.
Jean-Claude Juncker, veteran chairman of euro zone finance ministers, said he had tried to drive home that reality in a lengthy telephone call with Samaras on Monday.
"I... tried to make clear to him that there could be no substantial changes to Greece's adherence to the adjustment program," Juncker told Austrian ORF television.
With trust in Greek politicians at a low ebb, EU governments want to see a new administration implement long delayed public sector job cuts, privatizations and closures of loss-making enterprises as well as tougher anti-corruption measures.
The so-called "troika" of European Commission, ECB and International Monetary Fund will return to Athens next month to review Greece's implementation of its bailout commitment. It is almost certain to say the second adjustment program agreed earlier this year is already off track.
In an example of the domestic constraints facing euro zone governments, Germany's top court said Merkel's government did not consult parliament sufficiently about the configuration of Europe's permanent bailout scheme, but experts said it should not hamper Berlin's ability to react to the debt crisis.
The European Stability Mechanism (ESM) is supposed to come into effect in July but has not yet been ratified by many euro zone member states' parliaments, including Germany's Bundestag.
Additional reporting by Nigel Davies and Fiona Ortiz in Madrid, Kirsten Donovan in London, Lesley Wroughton and Luke Baker in Los Cabos, Jan Strupczewski in Brussels, Alexander Huebner and Stephen Brown in Berlin; Writing by Paul Taylor; editing by Janet McBride and Anna Willard