Spain seeks Arab funds for bank package

* Spain talks with Gulf Cooperation Council on debt

* Needs foreign financing to make bank package work

* Recession likely, key is fast financial recovery

MADRID, Oct 20 - Spain to Arab sovisereign wealth funds  appealing to buy public debt it will issue to pay for a bank aid package, Industry Minister Miguel Sebastian said in an interview.

Without investment from Gulf states and other countries, the package may fail to boost bank liquidity or lending and Spain's severe economic problems could drag on, Sebastian told Reuters.

"You can only increase liquidity in the system if we attract liquidity from abroad," Sebastian said, following talks last week with the Gulf Cooperation Council (GCC). "We are offering these sovereign funds the chance to buy Spanish bonds."

Spain's Socialist government plans to purchase up to 50 billion euros ($67.35 billion) in mortgage-backed-bonds and other bank assets to raise financial system liquidity and jump-start lending.

The Treasury will auction debt to pay for acquisitions of long-term, investment grade debt that banks cannot sell during current market turmoil.

Should domestic banks buy the paper, the plan will recycle funds around the Spanish financial system rather than create new liquidity for credit operations, Sebastian said.

"In that situation there is no net increase in liquidity, we have to go abroad to sell our new issues," said Sebastian.

PUBLIC DEBT BOOM

Sebastian, former chief economic advisor to Prime Minister Jose Luis Rodriguez Zapatero, said it was all but inevitable Spain would enter recession, despite Economy Ministry forecasts the economy will grow 1.6 percent this year and 1 percent the next after 3.7 percent in 2007.

"If by recession you mean two quarters of negative growth it's evident we are going to be really close," he said. "What's important is the speed at which we fix financial problems."

The comments follow a meeting in Madrid with GCC Secretary General Abdul-Rahman al-Attiyah to discuss purchases of Spanish sovereign and corporate debt.

The GCC's six member countries, including Saudia Arabia, operate state run sovereign wealth funds that are investment agencies using money from oil profits.

The funds worry some Western governments, which say they lack transparency and base investment decisions on politics.

Sebastian said they were essential to meet Spain's heavy foreign financing needs during turmoil in global money markets.

"We are sending the message we are open to investment, not only from these countries, but many others," he said. Spain has launched an international debt sale campaign, with the slogan "In Spain we Trust", after forecasting 2009 gross financing needs will increase 51 percent to 104.5 billion euros to cover a swelling public sector deficit.

Spain sees public borrowing as a means to speed recovery and says it can afford soaring issue costs, given a relatively low debt to gross domestic product ratio of 37 percent.

DEFAULT RISK

The debt campaign accompanies rising doubts over the ability of the bank aid package to unjam lending and spark the economic revovery Zapatero forecasts for the second half of next year.

If firms are starved of credit, unemployment will rise higher and Spain could enter a debt default spiral if banks cut lending even further, Sebastian said.

"An increase in bad debt will affect the financial system negatively and we will enter a situation in which bank solvency will deteriorate," Sebastian said, adding that such a scenario remained unlikely given banks' high bad loan provisions.

Some analysts see Spain's bank aid aimed at preventing solvency problems and the opposition conservative Popular Party says it will do nothing to boost lending because banks will just take the cash and sit on it.

Zapatero, and Economy Minister Pedro Solbes, have been non-committal over the issue, saying banks have control over their loan portfolios and must be allowed to make profits.

Sebastian, seen as a possible successor to Solbes, said the Industry Ministry was closely watching to see whether credit reached firms, especially small and medium sized ones.

"The financial issue will determine what happens here, it affects the whole economy," he said.