By Julien Toyer and Catherine Bremer
MADRID/PARIS (Reuters) - Spain is negotiating with euro zone partners over conditions for aid to bring down its borrowing costs, though the country has not made a final decision to request a bailout, three euro zone sources said on Thursday.
The favored option being discussed is that the existing European rescue fund, the EFSF, would purchase Spanish debt at primary auctions while the European Central Bank would intervene in the secondary market to lower yields.
No specific figure for aid has been discussed in the talks, which started several weeks ago, one of the sources told Reuters.
Other senior euro zone sources were more cautious, one saying nothing clear-cut had emerged on aid for Spain, while another said no talks were going on at all.
Spain's prime minister's office declined to comment. A spokeswoman for the economy ministry said there was no change in the Spanish position, which is that it would wait until the next meeting of the governing council of the European Central Bank on September 6, hoping for details on how the ECB plans to intervene, before deciding on any move.
Earlier this month Prime Minister Mariano Rajoy inched closer to asking for an EU bailout for his country, but said he needed first to know what conditions would be attached and what form the rescue would take.
ECB President Mario Draghi has said the central bank could intervene to lower painfully high yields but only if the country concerned asked for similar help from the bloc's rescue fund first.
Spain is the latest hot spot in the 2-1/2-year euro zone debt crisis after its ailing banking sector, which sought a 100-billion-euro European lifeline in June, and its highly indebted regions unnerved international investors earlier this year.
Last month, the country's borrowing costs reached their highest since the launch of the euro 13 years ago, a level seen as unsustainable in the medium-term.
On Thursday, the risk premium investors demand to hold Spanish 10-year paper rather than German benchmark rose to higher than 507 basis points, before falling to 500 on the Reuters report on the talks on a Spanish rescue. The dollar lost ground to the euro after the report, as well.
"Negotiations have started and are well under way. Right now the preferred option, the one that is being actively discussed, is for the EFSF to buy bonds on the primary market and for the ECB to buy bonds on the secondary," one of the sources told Reuters on condition of anonymity.
No formal announcement would be made before September 12 at the earliest, but things could move quickly after that.
The German constitutional court is due to rule on the European Stability Mechanism - the permanent European rescue fund - on September 12, before which Germany cannot ratify it.
Elections are being held in the Netherlands on the same day while EU finance ministers meet in Cyprus on September 14 and 15.
"Work is ongoing on this. It's a technical discussion on the terms and conditionality," another source who is close to French President Francois Hollande said.
One source pointed out that Spain may feel pressure to move quickly since Moody's ratings agency is due to revise the country's credit score in mid-September and government bonds could lose their investment grade status.
But two of the sources said any announcement would have to come several weeks after the finance ministers' mid-September gathering in Cyprus.
The office of EU Economic and Monetary Affairs Commissioner Olli Rehn said no negotiations were under way and a request was not expected any time soon.
A euro zone official told Reuters in July that Spain conceded for the first time at a meeting between Economy Minister Luis de Guindos and his German counterpart Wolfgang Schaeuble it might need a bailout worth 300 billion euros if its borrowing costs remained unsustainably high.
A full sovereign bailout, as given to Greece, Ireland and Portugal, would be much more expensive and stretch the currency bloc's resources to the limit.
The three sources who spoke with Reuters on Thursday said the negotiations were focusing on the conditionality of the aid, which will be included in a new memorandum of understanding.
While there is a political consensus that the conditions should be limited to what is already included in the European recommendations to Spain, which has pushed through a raft of painful austerity measures, two of the sources said euro zone countries were insisting on setting up a tougher schedule of monitoring for the reforms.
"There would be reports every three months and a very tight control of the budget and reforms," the first source said.
"Basically the conditions are already all included in the recommendations we made on May 31. Nothing more. Although we're looking at each of them one by one and making them more specific."
The ECB is participating in the negotiations but will leave it up to member states to decide on the strings attached to the aid, one of the sources said.
The Frankfurt-based institution is considering setting a yield target on purchases under a new bond-buying plan but without making the levels public, central bank sources told Reuters on Thursday.
Such an "implicit target" was one option being examined and would be flexible but nothing would be decided before the ECB's September 6 policy meeting, one source said.
Euro zone debt crisis graphics http://r.reuters.com/hyb65p
Spain, Italy bond spreads http://link.reuters.com/vur47s
Spanish economic overview http://link.reuters.com/quf25s
Separately, two of the sources said Spain's euro zone partners and the European Commission had dashed its hopes of getting an emergency liquidity line for its banks before the first tranche of up to 100 billion euros of aid is disbursed in the autumn.
Spanish authorities had hoped to receive up to 30 billion euros in August to start recapitalizing state-rescued banks, such as Bankia <BKIA.MC>, CatalunyaCaixa and NovaGalicia.
"Nobody is willing to disburse the money right now. At a recent meeting, Germany and France, as well as other member states and the European Commission asked Spain to provide more details on why this money is needed and where it would go," the first source said.
"Germany and the Netherlands also want to avoid any disbursement before September 12 and it is highly unlikely it will happen by then."
Another source said de Guindos did not want to request the emergency funds before the publication of a new bank by bank stress test, due by the end of September.
Spain and its euro zone peers are also finalizing the negotiation of the "bad bank" Madrid has been told to set up to clean up the banking sector from real estate assets, most of which are considered toxic after the burst of a decade-long property bubble four years ago.
A technical mission from the European Commission, the ECB and the International Monetary Fund will meet officials from the Bank of Spain and the Economy Ministry in Madrid on Friday, meaning the plan won't be adopted before August 31, when the Spanish cabinet next meets.
(Additional reporting by Luke Baker and Jan Strupczewski in Brussels and Carlos Ruano in Madrid; Editing by Fiona Ortiz, Mike Peacock and Giles Elgood)