European policymakers sought to squash talk of a euro zone rescue for Spain on Tuesday as the country saw its borrowing costs rise in a debt auction ahead of an EU summit to discuss steps to fix the currency bloc.

Germany's ZEW economic sentiment indicator suffered its biggest monthly drop since the height of the financial crisis in October 2008 -- right after the collapse of Lehman Brothers -- partly due to rumors about debt problems in Spain.

A German government official said he did not think that Spain, which was forced to deny media reports this week that it may soon require a Greek-style bailout, would be on the agenda of a European Union summit about stricter fiscal rules and economic reform on Thursday.

The chairman of euro zone finance ministers, Jean-Claude Juncker, said Spain was not comparable with Greece because of differences in economic fundamentals.

Financial markets shouldn't make the mistake of establishing an equivalence between Greece and Spain, Juncker told Reuters on a state visit to Norway.

Markets would one day be convinced that euro zone countries were doing the right things to deal with their debt crisis, he said.

A day after admitting that some Spanish banks were being frozen out of international credit markets, Madrid raised 5.2 billion euros in 12- and 18-month T-bills at an auction, but paid a significantly higher average yield than last month.

The euro and European stocks recouped early losses after the auction reassured investors that Spain was in no immediate financial danger and will be able to meet a 16.2 billion euro debt redemption due by the end of July.

This was another test, which they passed with flying colors, said Eric Wand of consultancy 4Cast. It's costing more, but still at a vaguely palatable level.

The next test is a more important 10- and 30-year bond auction on Thursday.

However, Marc Ostwald, bond strategist at Monument Securities in London, said the fact that Spain had paid far more than France called into question its top-notch rating from agencies such as Moody's Investor Service.

Moody's shocked markets on Monday by abruptly downgrading Greece's sovereign debt by four notches to junk status.

EU Economic and Monetary Affairs Commissioner Olli Rehn told the European Parliament the timing of Moody's decision as astonishing and unfortunate, saying it had not taken into account latest developments in the country.

Another credit watchdog agency, Fitch Ratings, said financial markets had overreacted to the euro area's sovereign debt problems, though traders were likely to keep testing the region's commitment to the single currency.

Fitch analyst Brian Coulton told reporters his agency had no plans to follow Moody's in downgrading Greek debt to junk.

SARKOZY BOWS TO MERKEL

The Mannheim-based ZEW economic think tank's monthly poll tumbled to 28.7 in June from 45.8 in May. The consensus forecast in a Reuters poll of 40 analysts was for a fall to 42.0.

ZEW economist Peter Westerheide said increased uncertainty on financial markets about debt problems in Spain had caused a significant weakening in German sentiment despite an improving economic situation.

Ahead of Thursday's EU summit, French President Nicolas Sarkozy bowed to German demands for tougher European budget rules and dropped his call for a separate economic government of the 16-nation euro zone with a dedicated secretariat.

After talks in Berlin on Monday, Sarkozy accepted a German proposal that euro zone states which persistently breach budget deficit limits should have their voting rights in the bloc suspended, even if that requires changing the EU treaty.

He also yielded to Chancellor Angela Merkel's insistence that closer economic government should involve all 27 European Union members and not just those that share the common currency.

In Rome, Foreign Minister Franco Frattini said Italy could veto new EU budget rules unless they cover private debt as well as public debt. Italy has the euro zone's second highest public debt-to-GDP ratio after Greece but lower private debt than many European partners.

STRESS TESTS

Amid persistent worries about the solvency of European banks, the Spanish daily El Pais quoted government sources as saying Madrid wants EU regulators to publish the results of stress tests of individual banks to restore confidence.

The Spanish Banking Association said the stress test results should be made public.

There was no comment from the government or the Bank of Spain, but a German government official, briefing reporters ahead of the EU summit, said publishing the data was a possibility among several options.

Germany, France and the European Central Bank have so far opposed such a move, advocated forcefully by U.S. Treasury Secretary Timothy Geithner, because they fear it could trigger more speculation against some European banks.

Economists say Europe could face a prolonged period of economic stagnation with zombie banks as Japan did in the 1990s unless governments act decisively to force banks to resolve bad debts and recapitalize, merge or shut down those in trouble.

France and Spain are both due to announce major structural economic reforms on Wednesday.

A reform of France's generous pay-as-you-go pension system is expected to raise the legal retirement age from 60 to 62 or 63, extend the contribution period required to receive a full pension and introduce extra levies on higher earners.

Spain's minority Socialist government, fighting a 20 percent unemployment rate, is seeking support among opposition parties to enact a major shake-up of the country's rigid labor market to make it easier to hire and fire, and reduce layoff payments.

(Additional reporting by Sarah Morris and Sonya Dowsett in Madrid, Jonathan Gould in Frankfurt, Andreas Rinke and Emmanuel Jarry in Berlin, George Georgiopoulos in Athens and Kirsten Donovan in London; writing by Paul Taylor, editing by Noah Barkin)

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