* Central bank head says budget based on too-rosy outlook
* Spain's borrowing costs fall at auction
* Markets bet on a rescue application from PM Rajoy
* Euro zone considers debt insurance scheme for Spain
* ECB's Draghi says conditions must be met for aid
By Carlos Ruano and Nigel Davies
MADRID, Oct 4 (Reuters) - Spain's central bank chief undercut the government's proposed 2013 budget on Thursday, saying it was based on over-rosy forecasts for economic growth and tax revenue.
Speaking to a parliamentary budget committee, newly-appointed Central Bank Governor Luis Maria Linde delivered a blunt message as Prime Minister Mariano Rajoy weighs when to seek an international bailout.
"This outlook ... is certainly optimistic in comparison with the outlook shared by the majority of international organisations and analysts," he said.
Linde said the government, which has already hiked taxes and cut tens of billions of euros in costs, should consider further steps this year to meet next year's deficit target of 4.5 percent of gross domestic product agreed with the European Union.
Expectations that Rajoy will request a euro zone rescue package before the end of the year lowered Spain's borrowing costs at a Treasury auction on Thursday of 4 billion euros in government bonds.
The yield on bonds due in 2014 dropped significantly to 3.282 percent from 5.204 percent when it was last sold in July.
But market pressure could return if Rajoy drags his feet on seeking a bailout or is held back by German reluctance to put more assistance for Spain to its parliament.
The European Central Bank has pledged to support Spain by buying its short-term debt on the open market, but only once Madrid signs up to the conditions attached to European aid.
"Markets are giving Spain the benefit of the doubt in anticipation of a rescue. Foreign investors need to see some sort of conditional backstop in place before seriously thinking about buying Spanish debt again," said Sassan Ghahramani, head of New York-based hedge fund consultancy SGH Macro.
The euro zone is considering aiding Spain by providing insurance for investors who buy government bonds in a move designed to maintain Spanish access to capital markets, shaping a rescue differently than the previous full bailouts of Greece, Ireland and Portugal.
The bond gaurantee scheme, which is under consideration and has not been decided yet, would achieve two important aims. Spain would be rescued without draining Europe's entire bailout fund and there would be no contagion to Italy.
ECB head Mario Draghi praised Spain's fiscal consolidation and economic reforms but reiterated that countries would have to make a formal application and sign up to strict conditions to benefit from the bank's bond-buying programme.
A rescue looks increasingly on the cards, as a prolonged recession complicates efforts to cut government spending.
Tens of thousands of protesters gathered near parliament in Madrid on three nights last week, demonstrating against the austerity measures and demanding changes in government.
Anger over costly rescue plans for banks has increased with one in four workers jobless. The shrinking economy has eaten into tax revenue and also pushed up unemployment benefit costs.
Much of the savings from aggressive cost-cutting have gone to servicing debt due to high borrowing costs.
Linde said most independent forecasters expect a 1.5 percent economic contraction in Spain next year, rather than the 0.5 percent fall on which the government based its calculations.
Rajoy sent a tough budget to parliament on Saturday with 13 billion euros in savings from spending cuts and tax increases.
The budget included a 1 percent increase in state pensions next year but Rajoy has not yet said whether he will maintain an inflation-pegged rise in pension payments as well.
Linde said an inflation adjustment to pensions would be so costly as to endanger budget execution.
The government is also taking on additional debt - some of it from European rescue funds - to bail out troubled banks and cash-strapped regional governments.
The central bank chief also urged ministers to make a prudent forecast for revenue next year, saying the tax-take outlook in the 2013 budget was subject to downside risks.
Fitch ratings agency also flagged the budget as unrealistic but said it would not downgrade Spanish bonds to junk status if the country sought a bailout and unlocked ECB bond-buying.
"Some of the assumptions certainly are optimistic in terms of the Spanish budget, nonetheless we do think that they're putting in place a programme which is consistent with giving support. And we'll give some tine to see how that will evolve," Fitch's head of sovereign ratings David Riley said in an interview with Reuters on Thursday.
Fellow credit watchdog Moody's is due to decide this month whether to downgrade Spain's sovereign rating to junk.
The yield on Spain's benchmark 10-year bond traded slightly higher on Thursday at 5.8 percent. In July, before Draghi announced the ECB's bond-buying programme, the Spanish 10-year yield spiked above 7 percent, a level seen as unsustainable.
Bankers, business leaders and opposition politicians have all heaped pressure on Rajoy to act soon on aid.
"The sooner the better," said Artur Mas, the president of the wealthy but cash-strapped northeastern region of Catalonia. Mas, who has stepped up talk of a Catalan secession from Spain in recent weeks, said it would be difficult for Catalonia, which represents one fifth of the country's economy, to meet deficit targets this year.
Spanish Economy Minister Luis de Guindos made clear in a meeting with investors in London on Thursday that Spain would apply for aid from the European rescue fund (ESM).
"The thing that is on their mind is to apply for the ESM assistance and the implications of that," a person who attended one of the meetings told Reuters.