By Paul Day
MADRID (Reuters) - Spain's short-term borrowing costs rose to their highest level since 1997 in a debt sale on Tuesday as investors worried the country will soon be forced to ask for international aid.
The euro zone's fourth-largest economy has become the focus of the regional debt crisis, with the country struggling to overcome recession and a costly banking sector restructure.
Yields on Spanish 10-year bonds have been trading above 7 percent, a level that is seen as unsustainable for Spain's shaky public finances.
The rise in Spain's longer-term interest rates put the sale of 3 billion euros ($3.77 billion) of bills in the spotlight ahead of a bond auction on Thursday.
There was good demand and the government met its target amount but the yield on the 18-month paper was the highest since November while the 12-month bill sold with the highest rate since before the birth of the euro.
"The yields are over 5 percent in both lines which is back at the levels we saw in November 2011 when the market was in huge distress and the ECB was forced to intervene," Credit Agricole rate strategist Peter Chatwell said.
Yields briefly fell after the auction but stayed over the 7 percent level at which other euro zone countries have been forced to ask for international help.
Borrowing costs fell sharply after the European Central Bank flooded the market with around 1 trillion euros in cheap credit through two long-term refinancing operations (LTROs), in December and February, but they have since leapt back up.
Spain is hoping the ECB will ride to its rescue again. Officials have repeatedly said the central bank needs to take action to stop the euro zone debt crisis from getting worse.
The country sold 2.4 billion euros of the 12-month T-bill at an average yield of 5.074 percent on Tuesday, compared with 2.985 percent at the last auction in May.
It sold 639 million euros of 18-month paper at an average yield of 5.107 percent after 3.302 percent last month.
Spain will face a bigger test in financial markets on Thursday when it auctions up to 2 billion euros of bonds maturing April 30, 2014, July 30, 2015 and July 30, 2017.
Spain's economy is under pressure and earlier this month asked Europe for up to 100 billion euros to recapitalize its banking sector, suffering from a property market crash and a rise in bad debts.
The government was pleased to have avoided asking for a full-scale sovereign bailout such as the ones taken by Ireland, Greece and Portugal.
With the Spanish economy more than twice the size of these three combined, economists say the rise in borrowing costs and the worsening outlook may soon force it to seek fresh aid.
The EU has a potential rescue fund of around 700 billion euros, but if Spain needed an aid package of a similar size to that of Ireland and Portugal before it, Madrid alone would suck up more than half of that, leaving the bloc exposed if Italy also came under attack.
"(That Spain will need additional aid) is not a foregone conclusion, but lacking policy responses, I don't see any alternative. But, if you go for a full-fledged bailout, they (other European countries) very quickly run out of resources," economist at Barclay's Capital Antonio Garcia Pascual said.
"If there are not sufficient funds, then what happens? A euro zone breakup? It's a possibility and the risk of it happening has increased."
Spain entered its second recession since 2009 in the first quarter and most economists expect the economy to continue to shrink into next year at least.
Unemployment is over 24 percent, more than half all young Spaniards are out of work and deep spending cuts to tame one of the euro zone's largest public deficits are expected to prolong the downturn as investment plummets.
Protests against the austerity measures, which include deep cuts to the country's treasured public health and education sectors, have been large and frequent but mostly peaceful.
However, with more than a million and a half of Spanish homes receiving no income at all, and poverty levels in the country rising faster than anywhere else in Europe, frustration is on the increase.
"The politicians have no shame, and the bankers ... this crisis is because of bad management on their part. Of course it affects you, especially in looking for work," said Tamara Blanco, 42, unemployed.
(Additional reporting by Claire Kane; Editing by Fiona Ortiz and Anna Willard)