Portugal's caretaker government, fighting to avoid a bailout, said on Wednesday a political crisis had caused irreparable damage after borrowing costs rocketed as it sold a billion euros in short-term debt.

The sale of 6- and 12-month treasury bills brought some temporary relief for a country grappling with soaring rates, political uncertainty, rating downgrades and a warning by local banks they may no longer be able to buy government debt.

But the yield on 12-month T-bills spiked to 5.902 percent from 4.311 percent three weeks ago, and on six-month bills to 5.117 percent from 2.984 percent, highlighting the financial pressure ahead of big redemptions this month and in June.

I suspect that as far as the market is concerned, funding at these levels can only be viewed as a temporary measure, said Peter Chatwell, rate strategist at Credit Agricole.

Portugal's cost of credit has leapt since the minority Socialist government resigned last month after a parliamentary defeat on tougher austerity measures, casting the country into political limbo. An early general election is set for June 5.

The finance ministry said the auction was a confirmation of the deterioration caused by the rejection of the austerity plan and promised to take all measures necessary to ensure liquidity and financing for the economy. But it denied talking with the European Union about how to meet borrowing needs.

Current interest rates make it possible to conclude that the damage caused by the rejection of the austerity plan is irreparable, a ministry statement said.

The government has previously held out hope that by steadily meeting budget goals and cutting spending it could regain investor confidence.

It admitted last week that the 2010 budget deficit had hit 8.6 percent of gross domestic product, far above its 7.3 percent target, but said this year's goal of 4.6 percent would be met.

Local banks delivered an unprecedented warning to the government on Monday to seek a short-term emergency loan to sooth market concerns ahead of the election, saying that under current conditions they cannot continue buying government debt.

There has been a very important signal from the banks for the future, said BNP Paribas analyst Ioannis Sokos. Portugal can still make it through April, but probably won't get to June without a bailout.

MOODY'S DOWNGRADES BANKS

Adding pressure on banks, Moody's rating agency followed up a one-notch sovereign downgrade and cut the creditworthiness of seven local banks by one or more notches, citing concerns over the banks' own situation and the government's ability to support them.

EU finance ministers meeting in Budapest at the end of this week will try to clarity from the caretaker administration on what sort of support, if any, it can seek ahead of the election.

The European Commission said on Wednesday there were no discussions about releasing aid because Lisbon has not applied for assistance.

The caretaker has said it will resist any bailout or a loan as they would impose tough conditions on the country. It has also said that as a caretaker administration it lacks the power and legitimacy to seek outside help -- a point hotly disputed by opposition politicians.

Lisbon's partners are anxious lest the financing problems reach a point of no return before a new government is in place, sapping confidence in the euro zone, but they cannot force Prime Minister Jose Socrates' hand.

IMF Managing Director Dominique Strauss-Kahn told Spanish daily El Pais on Wednesday the country needs to show it is taking the right steps.

The situation is in the hands of the Portuguese government... it has to prove to its creditors that it is taking the right steps, Strauss-Kahn said.

Two business newspapers said the public social security fund has been selling overseas financial assets in the last few days to help finance the state by buying sovereign debt at auctions.

Jornal de Negocios and Diario Economico said the Social Security Financial Stabilization Fund planned to buy T-bills in Wednesday's auction. But a Labour Ministry spokesman denied the fund bought any treasury bills at the auction.

Analysts say the high yields, which are higher than 10 percent for five-year bonds, are unsustainable. The fall in the value of the bonds also undermines its banks, who have been substantial buyers of government debt.

The rating actions follow the downgrade of Portugal's debt ratings and also reflect the weakened standalone credit profile of most Portuguese banks, Moody's said in a statement.

The banks concerned included Caixa Economica Montepio Geral, Caixa Geral de Depositos, Banco Comercial Portugues, Banco Espirito Santo, Banco BPI, Banco Santander Totta and Banco Portugues de Negocios.

Portugal has to repay over 4.2 billion euros in maturing bonds on April 15, and then another 4.9 billion euros in June. Including coupon payments and deficit financing, its requirements until June are put at 12 to 15 billion euros.

From the pure cash perspective, April should be OK, even with coupons and deficit financing, but then if the domestic bid disappears, there's not much room for maneuver, said David Schnautz, debt strategist at Commerzbank.

Portugal's benchmark 10-year bond yield hit a euro lifetime high of over 9 percent on Tuesday.

(Additional reporting by Sergio Goncalves, Filipa Lima and Elisabete Tavares, writing by Axel Bugge, editing by Paul Taylor)

Portugal