By Nigel Davies and Carlos Ruano
MADRID (Reuters) - Spain's borrowing costs fell on Tuesday, at the first sale of debt since the government announced a new austerity package, but not enough to suggest markets believe the country's finances are on a sustainable path with banking problems yet to be resolved.
Prime Minister Mariano Rajoy unveiled spending cuts and tax hikes worth 65 billion euros ($80 billion) over the next 2-1/2 years last week, in a bid to demonstrate that Madrid can curb its debts.
But market doubts about whether Spain can avoid a full-scale sovereign bailout have kept its debt costs elevated with 10-year yields again heading towards the seven percent tipping point.
New Bank of Spain Governor Luis Maria Linde also took aim at the country's banks, urging them to implement recapitalization plans quickly, whilst acknowledging for the first time that lenders which are not viable will have to be wound down.
Spain's troubled banking sector lies at the heart of concerns over the health of the euro zone's fourth largest economy, and a quick resolution to the sector's ills could help lower the amount investors demand to buy its debt.
Despite much work to be done, borrowing costs at Tuesday's short-term debt sale were sharply lower than a month ago, coming before a key test of appetite for the country's longer term issues on Thursday.
The yield on the 12-month bill was 3.918 percent, down from 5.074 percent last month, which was its highest in 15 years.
The yield on the 18-month bill was 4.242 percent compared with 5.107 percent at auction in June, right after Spain sought a bailout for its ailing banks worth up to 100 billion euros.
"Yields have come down by nearly a percentage point, so that's not to be sniffed at, and there's room for them to fall further, but we need details of the bank bailout," said Orlando Green, strategist at Credit Agricole.
Euro zone finance ministers are due to discuss the terms of Spain's bank rescue on Friday at 1000 GMT, a spokeswoman for the chairman of the euro zone ministers, Jean-Claude Juncker, said.
Spain's economy minister said Europe's debt markets were not functioning properly and investors outside the euro zone had no confidence in the euro project.
"There are no (debt) operations between nations in the monetary union and practically the only demand for Italian debt comes from Italians," Luis de Guindos was quoted as saying in Spanish newspaper La Vanguardia.
"A similar thing is happening in France and Spain."
Analysts agree there is little more Spain can do besides the reform work and austerity measures it is already committed to.
"The main challenge is to restore foreign investor confidence in Spain's sovereign paper, with the markets increasingly demanding a "game-changing" response from the EU/ECB to the latest phase of the crisis," said Raj Badiani, economist at consultancy IHS Global Insight.
KEY BOND AUCTION
The short-term debt sale preceded auctions of up to 3 billion euros of medium- and longer-dated bonds on Thursday, when the Treasury will sell paper maturing in 2014, 2017, and 2019.
Orlando Green, strategist at Credit Agricole, said the sales were likely to go well, but would again come at a price.
"Spain cannot continue to pay such high levels for its debt indefinitely. If yields do not fall it could bring into doubt the debt sustainability of the country," he said.
Domestic banks likely sucked up the bulk of the 3.56 billion euros sold on Tuesday, although analysts and market makers said they could be reaching a limit for absorbing sovereign bonds.
Analysts also fear the austerity measures could backfire on the government, driving the country into a deeper recession, which would in turn reduce tax revenues and make it harder for it to hit deficit targets.
Yields on Spanish 10-year debt dipped briefly last week after Rajoy outlined the new measures, but they have since risen back closer to 7 percent, a level seen as unsustainable in the medium term.
The Treasury has sold 65 percent of its planned medium- and long-term debt issuance for the year, having raced ahead of schedule at the start of the year when banks snapped up debt with cheap European Central Bank liquidity.
But a higher deficit target for 2012, agreed with the European Union, as well as a new mechanism to ease the regions' funding troubles, will force the Treasury to raise more money from investors than initially anticipated.
($1 = 0.8167 euros)
(Additional reporting by Sarah Morris, Editing by Julien Toyer/Mike Peacock)