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.

Nonetheless, borrowing costs at Tuesday's short-term debt sale were sharply lower than a month ago.

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."

Foreign investors have cut their exposure to Spanish and Italian sovereign debt, leading the states to rely more heavily on national banks to buy domestic paper. "This renationalization of capital markets is very negative," de Guindos said.

Speaking in parliament, new Bank of Spain governor Luis Maria Linde said banks' recapitalization plans should be realistic and implemented in the short-term. He also acknowledged for the first time that unviable lenders should be wound down.

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 sells paper maturing in 2014, 2017, and 2019.

Green said the sales would likely go well, but again would 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 around 15 basis points, leaving them close 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)

• A Permanent Economic Emergency