By Hubert Kahl

Madrid (dpa) - Spain's Socialists have ruled out forming a coalition government with Prime Minister Mariano Rajoy's conservative ruling People's Party (PP), which fell short of an absolute majority in elections.

Rajoy still wants to form the next government despite the dramatic loss of a clear mandate, but he has left open the question of who his coalition partner will be.

While PP still emerged as the strongest party in the vote, but it lost about a third of its seats and fell well short of the absolute majority it achieved in 2011.

The conservatives took 123 of the 350 seats in the lower house, 63 seats fewer than they won four years ago, official results showed. The party won 28.7 per cent of the vote.

The Socialists (PSOE) were also punished by voters with their worst showing since the return of democracy following the end of the Francisco Franco regime in 1975.

PSOE won 90 seats, or 22 per cent of the vote, losing 20 seats compared to the last election.

Both PSOE and the new liberal party Ciudadanos, or Citizens, rejected a coalition with the ruling PP.

However, Ciudadanos leader Albert Rivera said his party would abstain from a vote on Rajoy's candidacy, which would enable the PP to form a government.

PSOE rejected speculation about a likely grand coalition, with deputy party chief Cesar Luena saying they will vote against Rajoy and the PP.

"Given the relative parliamentary weights, the least fragile government may be a grand coalition between the PP and the PSOE," Edoardo Campanella, an economist at UniCredit Research in Milan, said.

"The main drawback of this alliance is that, if it does not last long, it would backfire, strengthening the popularity of those outside it," he said.

The uncertainty over who would form the next government unsettled investors. Markets were jittery on Monday, with the Ibex35 stock index falling by 2.8 per cent to 9446.60 points.

"The election result has led to an unprecedented degree of uncertainty," said Marco Protopapa, an analyst at JPMorgan Chase.

"Everybody says they had a good result, everybody says there is a need to agree on a coalition government, everybody says reforms are needed: This is Spain today, but it looks like yesterday's Italy," Italian Prime Minister Matteo Renzi said in his newsletter Enews.

Renzi said the Spanish elections were "very interesting for another reason. As it has happened already in Greece and Portugal, governments that apply strict austerity measures ... are destined to lose their majority.

"Now it will be interesting to see if Europe will realize that a shortsighted policy of rigour and austerity is leading us nowhere."

The leftist Podemos party and Ciudadanos earned seats for the first time.

Podemos, which means "We can," under the leadership of Pablo Iglesias, gained 69 seats, while Ciudadanos, which is also known as the Cs, won 40 seats.

Iglesias declared their success marked the "birth of a new Spain."

"We won the election and whoever wins the election must try to form a government," Rajoy said on Sunday night. "I will try to form a government."

In remarks from the balcony of the party headquarters, Rajoy told hundreds of supporters: "Spain needs stability, security, certainty and trust."

Socialist party chief Pedro Sanchez said voters had expressed their "desire for change," but congratulated Rajoy on the result.

A centre-right coalition of Rajoy's party and Ciudadanos would still fall short of an absolute majority, while a left alliance of PSOE and Podemos would also fall short.

European Commission President Jean-Claude Juncker said in Brussels that "it is up to the Spanish authorities to see how Spain will manage to equip itself with a stable government that can play its full role in Europe."

"Despite all the difficulties, we are very hopeful that a stable government can be formed so that Spain can continue to work in close collaboration with the European institutions and EU partners," said commission spokeswoman Mina Andreeva.