* Berlusconi threat to oust Monti raises political risk
Markets also unsettled by Spanish hesitancy on bailout
* Monti and Rajoy meet in Madrid
* Euro falls on uncertainty over Greece
By Julien Toyer and James Mackenzie
MADRID/ROME, Oct 29 (Reuters) - Spanish Prime Minister Mariano Rajoy kept financial markets guessing on Monday over whether he will seek a credit line from the euro zone's rescue fund but said he would do so ``when I think it is in the interests of Spain''.
At a joint news conference after talks in Madrid, Italian Prime Minister Mario Monti said it was vital that the European Central Bank's bond-buying programme to support troubled states be activated, a strong hint that Spain should take the plunge, since he also said Italy did not need a bailout.
``It is of paramount importance that the instrument is put to work, that it does not remain theoretical,'' Monti said.
Monti said earlier this month that if Spain were to request a credit line from the euro zone's rescue fund, triggering ECB intervention, it would calm financial markets.
While Rajoy maintained his ambiguity, he omitted previous demands to know more details of the ECB's bond-buying plan before making up his mind.
``The instrument is there and any country can ask for it if it finds it necessary. And I will do just that,'' he said. ``When I believe that it is in the interests of Spain to ask for it, I will ask for it. Until I reach this conclusion, I won't do it.''
Former Italian Prime Minister Silvio Berlusconi's weekend threat to withdraw support from Monti's government, and regional elections in Sicily in which a protest party led by a stand-up comic polled strongly, highlighted political risk in Italy.
Monti dismissed fears that his unelected reformist administration of technocrats could fall, saying: ``I think that the best thing for us to do is continue to work with a time horizon of spring 2013 as has always been our intention.''
Rome's borrowing costs have fallen since July, partly due to the European Central Bank's pledge to buy unlimited quantities of bonds if necessary to help states that request aid and accept strict conditions, but also on hopes that Monti may stay on after next year's general election.
Italian and Spanish bond yields rose on Monday, partly due to uncertainty in the euro zone's recession-stricken third and fourth largest economies. But Italy paid less than a month ago to sell 8 billion euros of six-month bills.
The euro also slipped on doubts over whether Greece, the country that triggered Europe's debt crisis, can agree to a deal on new austerity measures and its international lenders can figure out how to make its huge debts sustainable.
A German government spokesman rejected talk of any new write-down of Greek debt involving official creditors, saying German law would not permit such a haircut.
The European Central Bank has also refused to take any losses on its sizeable holdings of Greek government bonds, saying that would be illegal.
Some market players are concerned by signs that Rajoy, having almost completed this year's borrowing, will try to avoid the stigma of requesting a precautionary credit line from the euro zone's ESM rescue fund.
A Spanish government source said Rajoy was taking into account improving market conditions, some more encouraging macroeconomic data and progress in euro zone integration, such as steps towards a single bank supervisor, but he would have no inhibition about seeking aid if the situation deteriorated.
The risk premium on Spanish bonds has tumbled since ECB President Mario Draghi's move, some Spanish banks have regained money market access and the Treasury has almost cleared its 2012 issuance needs and can soon being to pre-fund 2013 borrowing.
But Spanish yields have stopped falling and some analysts expect them to rise the longer Rajoy holds off.
In a sign of the depth of the recession battering Spain, retail sales fell at their fastest pace on record in September, hit by a hike in value-added tax, after unemployment topped a record 25 percent in August.
Monti sought to nudge Rajoy towards applying for a rescue when the two men met in August in the belief that Italy would benefit indirectly from a backstop for Spain, European diplomats told Reuters. The International Monetary Fund is also pressing for Madrid to seek for a credit line soon, diplomats said.
But with market pressure far less acute since the ECB announced its bond-buying policy, the incentive for Rajoy to apply has waned. Germany, the biggest contributor to the ESM, continues to insist that Spain does not need a bailout.
Rajoy rebuffed a German proposal for a European super-commissioner with powers to reject national budgets, saying it could not be taken in isolation but only as part of a grand bargain on closer euro zone union. He said he was not personally in favour.
``We are giving a message that we really want greater European integration. We can't say something is this first, then something else, without saying where we're going,'' he said. ``As part of a variety of measures for fiscal union, it could be considered.''
In Italy, Berlusconi appeared to have cleared the way last week for a new political era by announcing he would not run in a general election due in April, raising the prospect of Monti retaining a guiding role in economic policy.
However, in a furious reaction to being sentenced to prison for tax fraud, the billionaire former premier threatened on Saturday to unseat the Monti government and make a comeback, raising new uncertainty over the electoral outlook.
Against this backdrop, Sicilians voted on Sunday for a new regional government, dealing a setback to Berlusconi's party in one of its strongholds and boosting the anti-establishment 5 Star Movement on a low turnout, first results showed.
A strong performance for the 5 Star Movement, after its success in local polls in May, would reinforce its status as the main vehicle for protest against Monti's austerity policies and disillusion with mainstream parties.
Greece's foreign lenders have refused to make any further concessions on changes to labour laws contested by a junior coalition partner, the country's finance minister said on Sunday, prolonging an impasse on a crucial austerity package.
Athens has been locked in talks with its EU and IMF lenders on the austerity package for months, but a final agreement has been held up by the small Democratic Left party's refusal to back the new wage laws.
The publication of a list of more than 2,000 wealthy Greeks with Swiss bank accounts, including well-known business and political figures, fuelled public anger at a rich elite suspected of tax evasion on a massive scale.
Newspaper Ta Nea reprinted the names and the magazine editor who first published the list appeared in court on Monday charged with violating data privacy laws. The case against Costas Vaxevanis was adjourned until Thursday.
``I was doing my job in the name of the public interest,'' Vaxevanis told a crowd of supporters outside court. ``Journalism is revealing the truth when everyone else is trying to hide it.''
The list, given to Greece by French authorities in 2010, contains the names of 2,059 Greek account holders at HSBC in Switzerland to be probed for possible tax offences.
Greek authorities have said there is no evidence that people included in the list have violated the law, but Greek media have criticised former ministers for not investigating.