* Bank of Spain sees GDP down just 0.1 percent in quarter
* Economists less optimistic than government about recovery
* Auction yields on short-term paper fall from June auction
* Data offers Rajoy welcome relief from corruption scandal
By Paul Day
MADRID, July 23 (Reuters) - Spain's economy came close to stabilising in the second quarter, its central bank said, nurturing government hopes the country could soon exit recession, though economists were less optimistic.
The data offered a welcome distraction to the ruling People's Party as it battles a corruption scandal, which a strong sale of short-term debt suggested has failed to dent investor sentiment towards Spanish assets.
For weeks, Prime Minister Mariano Rajoy and his aides have talked up the prospect of a quicker than expected recovery from the country's 18-month slump, with growth expected in the third quarter instead of the fourth.
Tuesday's Bank of Spain estimates that the economy shrank just 0.1 percent quarter on quarter between April and June offered some support for that view.
The country has been in or close to recession for five years last year took a 42-billion-euro ($55 billion) bailout for its banks, brought low when a decade-long property bubble burst.
A quicker than expected economic recovery would help to deflect attention from the political and media storm that has surrounded Rajoy since his People's Party's (PP) former treasurer implicated him in an illegal payments scandal.
Rajoy, who has denied wrongdoing and rebutted opposition calls for his resignation, will face questions about the scandal on August 1 in parliament, where the PP holds a large majority.
The central bank said GDP probably dropped 1.8 percent in the second quarter year on year after falling 2 percent a quarter earlier, when it shrank 0.5 percent quarter on quarter.
The announcement helped the Treasury sell 3.52 billion euros of 3- and 9-month bills, slightly beating its target.
Yields fell sharply, with the shorter paper selling at 0.442 percent, little more than half that seen at auction in June. That reflected broad-based improvement in demand for higher-risk assets since the world's leading central banks laid out their commitment to supportive monetary policies.
ANY RECOVERY SEEN MUTED
Economists still believe any recovery in Spain will be muted.
"Recent data flow has shown quite an improvement... consistent with some stabilisation in GDP, but not yet consistent with growth," economist at Deutsche Bank Gilles Moec said.
"But the Spanish government is still very far from completing its fiscal adjustment, so there will be a ceiling on domestic demand for two or three years."
Madrid last year passed a slew of austerity measures to tame one of the euro zone's highest public deficits, squashing already hobbled domestic demand, though has eased off on tax hikes and spending cuts so far this year.
The Bank of Spain said sentiment data pointed to an improvement in spending over the next few quarters, which could help lifting the economy from its slump, though the country remains very reliant on exports and international growth.
Analysts say that, while the recession may be nearing an end, job creation could still be months away.
Spanish unemployment in the first quarter was a record 27 percent, though is expected to fall for the first time in almost two years in the second, helped by a strong tourist season.
Spain's short-term debt costs have risen from record lows hit in April after the U.S. Federal Reserve said it would start slowing its money printing programme and on concerns of political upheaval in Portugal, though have since fallen again.
"It seems that worries about the Fed (stimulus scaleback) and the political situation in Portugal are subsiding and the market is returning to a situation of stability," analyst at brokerage M&G Valores Nicolas Lopez said.
But Spain's weak economy, housing slump and private sector deleveraging could once again prompt investors to start dumping Spanish debt as they did last summer when yields hit unsustainable highs, Ben May from Capital economics said.
"Spain may struggle to meet its fiscal goals and banks' bad loans are likely to rise. This may prompt Spanish government bond yields to climb and perhaps eventually force the government to seek outside financial assistance," May said.
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