MADRID - Spain paid the second-highest yield on short-term debt since the birth of the euro at an auction on Tuesday, reflecting a growing belief that the country will need a full sovereign bail-out that the eurozone can barely afford.

Spain's increasingly desperate struggle to put its finances right has seen its borrowing costs soar to levels that are not payable indefinitely. Italy, commonly regarded as too big to bail out, has been dragged along in its wake.

The Spanish Treasury sold ?3bn of three- and six-month bills as planned. Yields climbed, however, with the six-month paper jumping to 3,691% from 3,237% last month.

"The most important takeaway from this auction is that Spain was able get all its debt out the door," said Nicholas Spiro at Spiro Sovereign Strategies. "Still, in March, Spain was able to issue six-month debt at a yield of less than 1%. Now it is paying 3,7%."

Spain had cushioned itself by securing well more than half its annual debt needs in the first six months of the year when market conditions were more benign, but that advantage has evaporated.

On Friday, the government said it expected the economy to remain in recession well into next year, while the autonomous region of Valencia became the first to ask Madrid for aid to pay debt obligations it cannot meet. Others are expected to follow.

Spain's north-eastern region of Catalonia, responsible for a fifth of the country's output, said on Tuesday it was studying a government plan to help it meet a heavy funding schedule but would not decide whether to sign up until later this year.

On the secondary market, Spanish five-year government bond yields rose above 10-year yields for the first time since June 2001. Having to pay more to borrow shorter-term rather than longer-term is usually a sign that markets believe the risk of a default or debt restructuring has increased.

"The spread between five and 10 years moved to negative today, which is a classic sign the market thinks the current trends are unsustainable for Spain's fiscal dynamics," said Nick Stamenkovic, bond strategist at RIA Capital Markets.

The premium investors demand to hold Spanish 10-year bonds is now at its highest level since the birth of the monetary union, at 7,6%, while the cost of insuring Spanish debt against default has also hit record highs.

Ten-year yields of more than 7% have proved to be a tipping point that eventually led to bail-outs elsewhere in the eurozone, though Spanish Finance Minister Luis de Guindos insisted on Monday that Madrid would not need more aid.

Spain has already asked for up to ?100bn to recapitalise its banks, which have been battered by a four-year economic downturn and a burst property bubble.

The government has launched a fresh ?65bn package of tax rises and spending cuts designed to chip away at its debt mountain but which will probably drive the economy deeper into recession.

The alarming spiral of Spain's debt costs has banished any hopes that a bail-out of its banks, or a June European Union summit that gave the eurozone's rescue funds a green light to intervene in the markets, has put the debt crisis into abeyance.

Spain and Italy have called on their partners or the European Central Bank (ECB) to help ward off market pressure, although Italian Premier Mario Monti said on Monday the ECB did not have to leap into action just yet.

The ECB has cut interest rates but has shown marked reluctance to revive its bond-buying programme, the only mechanism that could lower borrowing costs at a stroke.

French Foreign Minister Laurent Fabius said further aid for Spain could take the form of an increase in Europe's rescue fund or action by the ECB.

"I hope it will not be necessary to intervene again," he told France 2 television. "If we have to intervene, it could be an increase in the firewalls ... or interventions by the central bank."

SPREADING PAIN

The eurozone as a whole is now subsiding into recession. Business surveys on Tuesday showed the currency area's private sector shrank for a sixth month in July with the downturn that began in its high debtors now becoming entrenched in Germany and France.

Rating agency Moody's lowered its outlook for Germany, the Netherlands and Luxembourg to negative from stable late on Monday, citing an increased chance that Greece could leave the eurozone, which could spark a wave of uncontrolled contagion. It also warned Germany and the other AAA-rated countries that they might have to increase support for Spain and Italy.

For investors, Spain has become the focus but Greece - where the debt crisis first exploded - remains a powder keg. Inspectors from the EU, ECB and International Monetary Fund returned to Athens on Tuesday to decide whether to keep the nation hooked up to a ?130bn lifeline or let it go bust.

The eurozone has said it will keep Greece afloat through August while the inspection takes place, but analysts say Athens cannot hope to meet its bail-out terms without more money or time.

The new Greek government is highlighting a deeper-than-expected recession for throwing it off course, while its lenders say it is failing to push through privatisations, market liberalisation and tax reforms. The government has failed so far to find nearly ?12bn of extra cuts stipulated by its agreement.

Prime Minister Antonis Samaras said Greece's economy could contract by more than 7% this year, having already shrunk over each of the past four years.

"There are certainly delays in this year's agreed programme and we must quickly catch up," Mr Samaras told party colleagues. "Let's not kid ourselves. There is still big waste in the public sector and it must stop."

Reuters