MADRID Spain, battling a debt crisis that is shaking its government, banks and companies, will soon issue new bonds to fund ailing lenders and indebted regions despite borrowing costs nearing the 7 percent level that drove other states to seek a bailout.
The move will dent the country's strong liquidity position and further worsen public finances under scrutiny from investors and European officials who fear the euro zone's fourth economy may go the same way as Greece, Portugal and Ireland.
In the latest sign of tensions within Spain over the state of the economy and the banks, Bank of Spain governor Miguel Angel Fernandez Ordonez announced on Tuesday he would step down on June 10, one month earlier than the end of his mandate.
The country's banks and regions, reeling from a burst property bubble, are at the heart of its economic problems and economists say there is little hope of emerging from recession until they have been reinforced.
A government source told Reuters on Tuesday that Spain would likely recapitalize Bankia, which asked for 19 billion euros on Friday, by issuing new debt and possibly drawing cash from the bank restructuring fund and Treasury reserves.
"There is a clear preference to tap the market. The other option (injecting state bonds directly into Bankia) is marginal," the government source said.
"The (bank restructuring fund) FROB has liquidity and can tap the market. The Treasury also has a strong liquidity position. We'll choose one or the other mechanism."
Spain's woes, combined with growing uncertainty about whether Greece will remain in the euro zone, has reignited the 17-nation currency bloc's debt crisis on nervous financial markets, prompting calls for more radical EU action.
European Commission President Jose Manuel Barroso called on Tuesday for European leaders to agree on a path to full economic union to reassure investors about the future of the euro area.
"It is very important, even if you believe that it doesn't come immediately, to define the trend, the objective," Barroso said in a speech in Brussels.
"It is very important also in terms of confidence for the investment in the euro area now. We will support an ambitious and structural approach which should include a roadmap and a timetable for a full economic and monetary union in the euro area," he said.
However, a major survey released on Tuesday showed support for European integration has fallen sharply across the 27-nation European Union since the debt crisis began, raising doubts about the political will for closer economic union.
Spain is paying an increasingly high price to issue debt. The risk premium demanded by investors to hold 10-year bonds compared to safer German debt reached its highest since the launch of the euro on Monday and yields remained close to that level at 6.47 percent on Tuesday.
Prime Minister Mariano Rajoy has said repeatedly - most recently on Monday - his government does not need outside financial help, but most economists disagree.
"The point about Spain is it's going to need some external support of some form," said David Owen, chief European financial economist at Jefferies.
"Whether that implies the European Central Bank buys bonds (in the secondary market) or moves lock, stock and barrel to quantitative easing over the next three months, certainly the situation at the moment is not sustainable."
Spain has been on an austerity drive to improve its finances but this had deepened a recession and worsened unemployment now affecting a quarter of the workforce and led to protests. Retail sales slumped by 9.8 percent on the year in April, the biggest fall since the series began in 2003.
NO ECB HELP
Spain has been hoping the euro zone's central bank will come to the rescue by restarting its dormant bond-buying program, designed to bring down borrowing costs for countries that have seen them soar during the debt crisis.
The ECB also helped banks, struggling for cash, with two exceptional issues of long-term loans totaling 1 trillion euros. Many banks used the money to buy more government bonds.
But ECB policymaker Ewald Nowotny said on Tuesday there had been no discussion of restarting bond purchases or long-term loans and that it was up to national governments to help banks.
Foreign minister Jose Manuel Garcia-Margallo said in a television interview said Spain would recapitalize its banks, nursing hundreds of billions of euros worth of toxic assets from a 2008 real estate bust, without international help.
The government source said Madrid was worried the funding needs of the banks could weigh on the capacity of the state to finance itself.
Spain has already completed more than 55 percent of its debt issuance for the year and has at least 20 billion euros in its coffers, on top of more than four billion euros still available in the bank restructuring fund, making it possible to recapitalize the ailing lenders and repay debt.
However, the central government and regions still have to refinance 98 billion euros out of 117.5 billion euros of debt maturing in 2012 and fund a deficit of 52 billion euros.
The next three months, with 38 billion euros to refinance by August, and a second hump in October, when 28 billion euros is due, will be especially difficult.
The funding situation is also growing tense in the autonomous regions, with 12 billion euros of debt maturing in the last quarter, more than half of it in the two most-indebted regions, Catalonia and Valencia.
The source also said the government would adopt on Friday a new mechanism for the Treasury to provide funds to the regions, with strict conditionality.
"The Treasury will issue and distribute the debt. Strict conditions, such as meeting deficit targets or implementing austerity plans will be attached," the source said.
Spain is also trying to strengthen the financial system by encouraging a series of bank mergers.
The Spanish central bank governor said in a statement his resignation would help his successor as well as the Bank of Spain to deal efficiently with the ongoing banking reform as well as an external audit of lenders due for the end of June.
Bankia has asked for a total of 23.5 billion euros, including Friday's 19 billion euros, but many other banks are in trouble, suffering from bad loans that have climbed to an 18-year high, mostly linked to real estate.
Garcia-Margallo said decisions about the other lenders would come after an external audit of the sector in June.
Liberbank, an unlisted savings bank, said on Tuesday it was in talks about a merger with rivals Ibercaja and Caja 3.
Separately, Popular bank said it had started negotiations to sell a majority stake in its Internet banking business to reinforce its capital position.
(Additional reporting by Nigel Davies, Sonya Dowsett and Jesus Aguado in Madrid and Kirsten Donovan in London; editing by Anna Willard and Paul Taylor)