Spanish borrowing costs fell at an auction on Thursday despite a grim economic backdrop that has pushed the government to step up its drive for leeway from Brussels on its difficult debt cutting targets.

In the latest sign that Spain is entering a recession, its manufacturing sector shrank for the tenth straight month in February, a survey showed on Thursday.

But a flood of liquidity from the European Central Bank has allowed Spain to frontload its debt issuance for the year. It had completed almost 40 percent after successfully selling 4.5 billion euros of debt on Thursday.

With unemployment stubbornly high at 23 percent, and the economy expected to contract by more than 1 percent this year, the government is digging in its heels on the deficit.

Prime Minister Mariano Rajoy, elected last year pledging draconian spending cuts, is now lobbying Brussels for leniency, arguing the deteriorating economy makes it impossible to cut spending by more than 40 billion euros this year to reach a deficit target of 4.4 percent of gross domestic product.

A government source told reporters late on Wednesday that Spain would still be in compliance with European Union agreements on fiscal stability even if it did not hit the 4.4 percent target.

Tough spending cuts and recent economic reforms all show a commitment to fiscal stability and Spain will be on track to hit the ultimate goal which is a deficit of 3 percent of GDP in 2013, the source said on condition he not be identified.

Madrid said this week that its 2011 budget deficit was 8.5 percent of GDP, 2-1/2 percentage points above a 6 percent target, putting the 2012 goal almost certainly out of reach.

DEFYING BRUSSELS

The government will present its 2012 spending ceiling on Friday, a key step in preparing its budget. Another government source said the limit would be calculated based on a deficit target of around 5.3 percent to 5.5 percent.

That would imply cost cuts of 30 billion euros and would be in defiance of Brussels, where officials insist Spain must present a budget based on the 4.4 percent target and that there will be no room for discussions on relaxing it until May.

However, Foreign Minister Jose Manuel Garcia Margallo said in a television interview on Thursday that Spain does not expect Brussels to relax the deficit target by more than a few decimal points.

Rajoy plans to present his completed budget on March 30 despite pressure from Brussels to finish it sooner.

EU sources say Rajoy will have little opportunity to raise the matter of Spain's deficit at a summit of European leaders starting later on Thursday, because it is a matter for the European Commission, the EU's executive.

The 2012 budget will have to comply with the recommendations (the current deficit target) ... It is only in that context that the targets could be discussed, not at the European Council, a senior EU official told Reuters.

The official said that the commission is open to discuss this with Spain, but first it needs more details about the 2011 fiscal slippage, whether it was structural or the result of one-offs, as well as the 2012 budget.

Two senior officials told Reuters earlier that Germany, France, Britain and a handful of other countries were supporting Rajoy's push for softening the 2012 target.

The original public deficit target was based on an economic growth estimate of more than 2 percent, but now Spain's economy is expected to shrink by at least 1 percent this year.

SMOOTH DEBT ISSUE

Spain's borrowing costs fell at Thursday's triple bond sale taking the country further away from acute funding levels of close to 7 percent last year.

Spain has restructured its ailing banks, reformed its labor market laws to make it cheaper for companies to hire and fire and threatened sanctions on overspending local governments to avoid being sucked into the euro zone debt crisis that pushed Greece, Ireland and Portugal into needing bailouts.

France also had a successful debt auction on Thursday, selling close to 8 billion euros worth of bonds at lower yields thanks to the ECB's 3-year liquidity boost for banks.

Banks in Spain are taking the cheap funding, offered on Wednesday and in December, from the ECB and investing it into higher-paying sovereign bonds.

Analysts said the auction, ECB liquidity and possibly a positive outcome at the EU summit this week would support prices for Spanish bonds on the secondary market, narrowing the spread between its 10-year benchmark and German benchmark bonds.

However, we rule out that the extent of the tightening movement will be massive as fundamentals are not so favorable, with risks of a deep recession still looming on the euro zone periphery, said Annalisa Piazza, market economist at Newedge Strategy in London.

(Additional reporting by Andres Gonzalez in Madrid and Julien Toyer in Brussels. Writing by Fiona Ortiz, editing by Mike Peacock/Anna Willard)

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