MADRID/BRUSSELS (Reuters) - Spain's borrowing costs will probably hit a new euro era high at a debt auction on Thursday, a few hours before it sheds light on the dire state of its weaker banks and possibly makes a formal request for European Union funds to rescue them.
Madrid should show that it can still borrow on financial markets at the sale of short and medium-term bonds. However, the amount raised will be modest and the price punishingly high as international investors steer clear of Spain, leaving the often troubled domestic banks to buy up the bonds.
Spain faces a hectic day on Thursday as the latest euro zone country in the firing line following Greece, Ireland and Portugal which have already taken sovereign bailouts.
In the morning the Treasury aims to borrow up to two billion euros ($2.5 billion) and in the afternoon the government will release an independent audit of the banks, which have been hammered by the effects of a property crash and a recession.
Then in the evening, Spain could make the formal request for up to 100 billion euros in aid for its weaker banks at a Luxembourg meeting of euro zone finance ministers, who already approved the plan informally earlier this month.
A lack of information on the bank rescue has helped to drive yields on Spanish government debt in recent weeks to levels at which the other struggling euro zone countries had to seek full sovereign bailouts, rather than just aid to recapitalize banks.
"The lack of details right now only serves to damage the situation. I say that as soon as we have the details of the audit, then we should ask for the plan to be enacted," said a senior EU diplomat.
Yields on the secondary bond market indicate that the Treasury's borrowing costs on five-year debt at Thursday's auction will be the highest since 1996, three years before Spain joined the euro. It will also sell two shorter-dated bonds.
Even a reduced target of one to two billion euros may prove hard to meet, with the international investors shunning the bonds as they fear the government will be forced to take outside aid to back its own finances.
The auction will be followed by the results of the external audit of the banking system. Banking sources believe this will say the lenders need to raise a further 60-70 billion euros to improve their capital position.
Spain could use the audit results to request the bank aid quickly, according to several sources who said details would then be hammered out afterwards.
Two EU officials also said they expected the aid request to be made on Thursday or Friday. A Spanish government source said a final decision had not yet been made but an announcement could be made in Luxembourg.
The audit conducted by consultancies Oliver Wyman and Roland Berger is likely to divide the banks into three groups: the weakest regional savings banks heavily exposed to over-valued real estate assets, a group of mid-size banks which could face temporary liquidity problems and two 'good' banks - BBVA (BBVA.MC) and Santander (SAN.MC) - that won't need any help.
This exercise, which tested the banks' ability to handle trouble in the overall economy, will be followed by a more detailed review of the banking system due by July 31.
The Treasury plans to sell three sets of bonds on Thursday, with the yield on a five-year bond expected to be above 6 percent, the highest in 16 years. The 10-year bond yielded just below 7 percent late on Wednesday, after reaching a record 7.3 percent earlier this week.
Economy Minister Luis de Guindos said on Monday that this level was not sustainable - meaning it is unaffordable in the medium term - and he has backed the creation of a European fiscal and banking union to calm the euro zone debt crisis.
The Treasury will also sell a bond maturing in 2014, and another in 2015 on Thursday, with yields on both forecast to be over two percentage points higher than when they were last sold in March and May respectively.
Spain will have sold around 60 percent of its planned issuance in medium and long-term debt after Thursday's auction, as it got ahead of schedule at the start of the year when banks used cheap cash from the European Central Bank to buy bonds.
The effect of the massive ECB loans of three-year cash is fading fast.
"The small size on offer should ensure that there is sufficient demand at the auction, predominantly from domestics," said Jamie Searle, analyst at Citi.
Yet ultimately not much will change after the auction. "Spain has already admitted that it needs help to recapitalize its banks and...eventually, Spain may require further help at the sovereign level," said Searle. ($1 = 0.7889 euros)
Additional reporting by Julien Toyer; editing by David Stamp