Summit doubts to drive up Spain's debt costs

Struggling debtor Spain is likely to pay its highest short-term borrowing rates in over six months on Tuesday as investors demand high premiums, skeptical about euro zone leaders' readiness to act decisively to tackle the bloc's problems.

Spain formally requested European aid worth as much as 100 billion euros for its troubled banks on Monday, but that failed to assuage doubts about how the country can repair its finances as it sinks into what many fear will be a deep and prolonged recession.

The Treasury will issue between 2 billion and 3 billion euros ($2.5 billion-$3.8 billion) of 3- and 6-month T-bills on Tuesday. While demand, mostly from domestic banks which have been cut off from international markets, is expected to be solid, Madrid will probably be forced to pay dearly.

Rates on the bills on the secondary market stood at around 1.8 percent for the shorter-dated paper and around 2.7 percent for the longer maturity on Monday, almost double those at the last primary auction in May and levels not seen since November.

Italy sells zero-coupon and inflation-linked bonds later in the day and before European leaders meet on Thursday and Friday for their latest attempt to address their 2-1/2 year old debt crisis.

"We are not anticipating anything from the summit that will clear up market doubts. We might get some clarity on attempts to increase European rescue funds, and Spain's bank rescue package, but the risk is that it disappoints," said Orlando Green, strategist at Credit Agricole.

He expects domestic banks to take up enough of the paper.

But struggling banks who have loaded up on what was once deemed 'risk free' sovereign debt have become part of a vicious cycle that EU leaders are expected to discuss when they meet in Brussels.

SOVEREIGN-BANKS LINK

The auction follows a downgrade of long-term debt and deposit ratings for 28 Spanish banks and two issuer ratings by Moody's Investors Service on Monday.

Among the downgrades was a cut to Banco Santander's long-term rating to Baa2 from A3. But the rating is under review for further downgrade, meaning more cuts could be forthcoming to the euro zone's largest banks.

The Spanish government was forced to pay euro-era high rates on one- and five-year debt last week on expectations Madrid could be forced to seek a full-scale sovereign bailout following a first package targeted only at its banks.

Last week's auction meant Spain has now sold just over 61 percent of its planned medium- to long-term debt issuance after it took advantage of two bursts of cheap funding from European Central Bank auctions in December and February that encouraged banks to buy sovereign debt.

Since then the country's financing costs have touched euro era record highs. Late on Monday a major risk measure, the difference between its 10-year bond yield and that of Germany, was 507 basis points, down from over 580 hit last week.

Domestic banks continue to provide the last line of support for the Treasury, with international investors unwilling to tap into Spanish debt even with a short maturity date.

Data on Monday showed the ECB failed to restart its government bond purchase program to help debt issued by countries in the euro zone's weaker economies despite pressure from the Spanish government for the central bank to help.

($1 = 0.7977 euros)

(Editing by Julien Toyer/Ruth Pitchford)

By Paul Day and Nigel Davies

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