Markets give up hopes for lasting euro zone solution (Reuters)

By Steven C. Johnson Steven C. Johnson – 1?hr?49?mins?ago

NEW YORK (Reuters) – After another week of confusion and turmoil in Europe, investors are ditching whatever hopes they once had for a conclusive solution to the debt crisis.

That may foreshadow a gloomy holiday season in markets, especially if wary investors opt to reduce risk in their portfolios and take refuge in U.S. Treasuries and the dollar.

Just weeks after it seemed leaders had drafted a master plan to solve the crisis, doubts rose about whether Greece would back a 130 billion-euro bailout.

Disaster may have been averted when Greece, under fierce EU pressure, agreed over the weekend to form a new government that would approve the deal and stave off bankruptcy.

But that did little to calm investors, who were already looking ahead to the next problem: Italy. Italian bond yields hit a euro-era high of 6.4 percent Friday, raising fears the country may soon need a Greece-style emergency bailout.

The Greek agreement "may spark a brief relief rally," said Alan Ruskin, head of global G10 currency strategy at Deutsche Bank. "But it won't last and we will soon go back to focusing on Italy."

"At the end of the day, it does seem like a grand plan is elusive at best," said David Ader, head of government bond strategy at CRT Capital Group in Stamford, Connecticut.

"We've seen one European bank and one U.S. brokerage fail. We know there are strains for French banks. We're wondering how long it will be before Greek default worries spread to Italy and Spain," he said. "In a situation like that, money managers are going to decide to simply take their risk down."

FLIGHT TO SAFETY

Investors are betting the market will see evidence of that as soon as this week, as flight-to-safety flows help boost U.S. Treasury debt, lift the dollar against the euro and weigh on stock markets around the world.

The biggest fear is that a disorderly default in Greece or elsewhere would ripple across the global financial market the same way the Lehman Brothers collapse did in 2008. That, investors fear, would probably be enough to plunge the global economy into recession.

"This is going to be pretty negative news for risk markets," said Jack Ablin, chief investment officer at Harris Private Bank in Chicago. "We are going to see a continued flight-to-quality tomorrow."

Benchmark U.S. 10-year note yields dropped more than 29 basis points in the past week and a half as worries about Europe overshadowed signs of economic improvement in America.

Ashraf Laidi, CEO of Intermarket Strategy in London, said he expected the euro to struggle again this week after losing nearly 3 percent against the dollar last week. By year end, he said it could fall below $1.30. It was around $1.38 Friday.

"This past week really raised some tricky questions," he said. "For the first time I can remember, the possibility that Greece really could leave the euro zone was being talked about in cafes and bars as well as on trading desks."

The weekend deal in Greece may stabilize things a bit in that it suggests Greece will keep the emergency funds flowing while making the tough spending cuts needed to get its fiscal house in order.

"What we had been afraid of was a stalemate. Now it seems the hard cuts will be made. I think equity markets will cheer this," said Michael Yoshikami, president and chief investment officer at YCMNET Advisors in Walnut Creek, California.

The cheering may not last long, though.

"These 24-hour risk-on rallies, I don't know how much longer people are going to be willing to do that," said Ader. "Sell-offs are getting deeper because the rallies are only short-covering moves. People are not getting long and putting on bets that everything is suddenly OK."

FROM GREECE TO ITALY

Deutsche Bank's Ruskin said the focus is likely to shift quickly from Greece to Italy in the weeks ahead, and that should mean more volatility and unwillingness to take on risk.

Italy's debt-to-output ratio stands at 120 percent, second only to Greece in the 17-country euro zone, and its borrowing costs are rising.

Prime Minister Silvio Berlusconi recently refused a loan offer by the International Monetary Fund and his government may be on the verge of collapse.

"Berlusconi says Italians are not feeling the crisis but that's because the European Central Bank has been providing high levels of liquidity at low interest rates and buying Italian bonds," Ruskin said. "That begs the question, should the ECB stop that to show them this is really a crisis?"

"I have to believe a lot of investors like me are thinking this could be the start of Italy week," said James Paulsen, chief investment strategist at Wells Capital Management in Minneapolis. "Italy is going to rapidly rise on investor radar screens and may be the bigger story."

(Additional reporting by Richard Leong, Daniel Bases, Karen Brettell in New York; editing by Bernard Orr)

View the original article here

Greek gloom rocks markets, troubles lenders (Reuters)

By Harry Papachristou and Jan Strupczewski Harry Papachristou And Jan Strupczewski – Mon?Oct?3, 8:29?am?ET

ATHENS (Reuters) – Greece's admission that it will miss its deficit target this year despite harsh new austerity measures sent stock markets reeling on Monday and raised new doubts over a planned second international bailout.

The gloomy news from Athens brought the specter of a debt default closer and will weigh on talks among euro zone finance ministers in Luxembourg later on Monday on the next steps to try to resolve the currency area's sovereign debt crisis.

European bank shares suffered the heaviest falls on fears that private sector bondholders may be forced to absorb bigger losses than agreed in a July rescue plan for Greece, which was based on more optimistic growth forecasts.

The draft budget sent to parliament on Monday showed this year's deficit would be 8.5 percent of gross domestic product, well off the 7.6 percent agreed in Greece's EU/IMF bailout program.

Finance Minister Evangelos Venizelos said in a statement that the 2012 fiscal targets would be met in absolute terms and Greece would have a primary surplus before debt service for the first time in many years.

However, next year's deficit is projected to be 6.8 percent of GDP, rather than the 6.5 percent EU/IMF goal, because the economy is set to shrink by a further 2.5 percent after a record 5.5 percent contraction in 2011.

Deeper-than-forecast recession means public debt will be equivalent to 161.8 percent of GDP this year, rising to 172.7 percent next year, by far the highest ratio in Europe.

Deputy Finance Minister Pantelis Oikonomou said the European Union and International Monetary Fund inspectors had "essentially concluded" negotiations to give Greece a crucial 8 billion euro installment of aid this month to avert bankruptcy.

However, a source familiar with the review by the "troika" of international lenders said the talks were not over, and the inspectors were still examining both the budget numbers and other reforms required for the loan disbursement.

The 17 euro zone ministers will not take any decision on Monday on releasing the funds, needed to pay October salaries and pensions, since the troika has yet to report back. They are set to decide at a special meeting on October 13.

The likelihood that Greece's funding needs next year will be greater than forecast when a second 109 billion euro rescue package was agreed in principle in July reopened a fraught battle over who should pay -- taxpayers or financiers.

STEEPER HAIRCUT?

Deutsche Bank chairman Josef Ackermann, head of the International Institute of Finance (IIF), which negotiated a "voluntary" bond-swap by investors as part of the bailout plan, warned at the weekend against changing the terms now.

"If we reopen the voluntary accord of July 21, we will not only lose precious time but quite possibly also private investor support," Ackermann told the Sunday edition of Greek newspaper Kathimerini.

"The impact of such a move will be incalculable. This is why I am warning in the most forceful way against any material revision," he said.

Private bondholders agreed to a 21 percent write-down on their Greek debt holdings but EU and German officials have suggested the "haircut" may have to be increased in light of a new funding shortfall and changed market conditions.

"Ultimately, Greece would need to see its debt written down by more and with that you need probably some kind of shoring up of the banking sector," said Alec Letchfield, chief investment officer at HSBC Asset Management.

Political resistance to pouring more public money into euro zone bailouts is growing across northern Europe.

"Greece is bankrupt," said Michael Fuchs, a deputy parliamentary floor leader in German Chancellor Angela Merkel's Christian Democrats, reflecting a growing mood in Berlin.

"Probably there is no other way for us other than to accept at least a 50 percent forgiveness of its debts," Fuchs told the Rheinische Post newspaper.

FLIGHT TO SAFETY

Uncertainty over the extent of damage to the already fragile European banking sector from a possible Greek default has been driving investors to take refuge in safer assets.

Yields on Spanish and Italian government bonds rose and the cost of insuring their debt against default spiked on the news from Greece, while money poured into safe-haven German Bunds. The euro fell to an eight-month low in Asia.

"The markets continue to conclude that a default for Greece is an inevitability and a question of when rather than if," said Nick Stamenkovic, strategist at RIA Capital Markets.

The euro zone ministers were expected to discuss ways to leverage their EFSF bailout fund, without reaching a conclusion on Monday, and to put more pressure on Greece to implement agreed structural reforms and privatizations to try to get its economy growing again.

Economic and Monetary Affairs Commissioner Olli Rehn said Europe faced a triple challenge of "stalling growth, stressed sovereigns and still vulnerable banks".

Ministers would review options to enhance the financial firepower of the rescue fund, some of which involved leveraging with money from the European Central Bank, he said.

The debt and GDP projections illustrate how Greece has fallen into a vicious spiral of recession, falling revenues, soaring unemployment and declining consumer purchasing power.

Officials expect the next aid tranche will be paid, because the euro zone will not be ready to cope with the fallout of a Greek default until its bailout fund, the European Financial Stability Facility (EFSF), gets its new powers of market intervention ratified in the next two weeks.

Even then, however, while the 440 billion euro fund will be able to buy government bonds from the market, recapitalize banks and extend precautionary credit to sovereigns, it may not have enough cash to cope with all the financing needs.

The leveraging idea, suggested by the United States, has opponents in north European creditor countries, who fear it could lead to bigger liabilities beyond the 780 billion euros in current EFSF guarantees, or credit rating downgrades for either the AAA-rated rescue fund or its triple-A guarantors.

Among the ideas under consideration is allowing the EFSF to refinance itself at the ECB's liquidity operations for banks. The EFSF could also guarantee to cover a percentage of potential losses investors could incur in case of a hypothetical sovereign default.

Any solution, however, should not require another round of ratification, officials said, because policymakers realized how difficult and lengthy the process was given the growing opposition to bailouts in many euro zone countries.

(Additional reporting by Ingrid Melander, Dina Kyriakidou and Lefteris Papadimas in Athens, Dominic Lau and William James in London, Annika Breidthardt in Luxembourg; Writing by Paul Taylor, editing by Mike Peacock)

View the original article here

Markets look to Fed after ECB buys bonds (Reuters)

WASHINGTON/LONDON (Reuters) – Investors are looking to a meeting of the Federal Reserve on Tuesday for signs of further support for reeling financial markets and the economy after the European Central Bank stepped in to buy Italian and Spanish government bonds in the latest attempt to deal with the euro zone debt crisis.

Over the weekend the G7 and G20 group finance ministers pledged coordinated action to ensure financial market stability and economic growth after world stock markets lost $3.4 trillion in value since July 29 on investor concern that slowing global economic growth would make it even harder for heavily indebted countries to pay their debts.

Late Friday the United States lost its prized AAA credit rating from Standard and Poor's, reflecting the agency's fear that political gridlock in Washington, D.C would prevent the government from cutting its budget deficit and reducing its debt.

U.S. President Barack Obama on Monday said he hoped Friday's credit rating downgrade will give Congress a new sense of urgency to tackle the government's budget deficit.

Stock markets around the world fell further on Monday and investors rushed into safe-haven assets like U.S. Treasury debt, despite the U.S. rating downgrade, as well as gold. Gold soared to almost $1,720 an ounce in its biggest surge since March 2009. Major U.S. stock market indices were down about 5.0 percent by mid-afternoon after European stocks fell to a two-year low.

"The sell-off is mainly due to the fear that we will relapse into recession," said Klaus Wiener, chief economist at Generali Investments, which manages 330 billion euros ($468 billion). "Many investors have finally realized that the U.S. economy will not grow at 3.0 percent."

ECB TO THE RESCUE

In Europe, traders estimated the ECB bought about 2 billion euros in Italian and Spanish debt after it agreed on Sunday to broaden its controversial bond-buying program for the first time to include the bloc's third- and fourth-biggest economies.

After a rare Sunday night conference call, the ECB welcomed announcements by Italy and Spain of new deficit-cutting measures and economic reforms as well as a Franco-German pledge that the euro zone's rescue fund will take responsibility for bond-buying once it is operational, probably in October.

"It is on the basis of the above assessments that the ECB will actively implement its Securities Markets Program," ECB President Jean-Claude Trichet said in a statement.

The central bank action aimed to change the dynamics on bond markets that had been pushing Italian and Spanish borrowing costs up toward unsustainable levels since mid-July.

Since the program began in May last year it has bought just 76 billion euros of bonds, while Italy and Spain alone issue around 600 billion a year.

"The intervention by the European Central Bank this morning seems to have been working," Irish Finance Minister Michael Noonan told RTE public radio.

"Last week the risk was that as bond rates in Italy went toward 7.0 percent, they'd be driven into some kind of bailout program. They have fallen by almost one percent this morning so they are well out of the bailout territory now."

Spreads of Italian and Spanish bonds over German debt narrowed sharply and the cost of insuring peripheral European debt against default fell. But French sovereign credit default swaps hit a record high of 160 basis points as the U.S. rating downgrade raised questions about how long other AAA countries, such as France, could hold onto their top-notch ratings.

The ECB move was seen as only a temporary solution however, due to the sheer size of Italy's bond market -- $1.6 trillion.

Longer term, more profound measures need to be taken or some of the euro zone risks breaking up, some analysts said.

"They can keep it up for some weeks but I don't think it can have a lasting impact on the market," said Glenn Marci, interest rate strategist at DZ Bank.

However, European stocks sank to their lowest in nearly two years on Monday as doubt about governments' ability to deal with the euro zone debt crisis and its impact on economic growth emerged.

Berlin denied that Germany and France had made any stronger promises about the euro zone rescue fund's commitment to buy bonds of weak member states in the secondary market, after the ECB singled out that pledge.

A bailout of Italy would overwhelm the EFSF's existing resources. Germany has so far opposed expanding it but French Finance Minister Francois Baroin said: "The allotment is 440 billion and we've already said if we need to go further we will go further."

Over the weekend the Group of Seven major industrial nations -- the United States, Britain, Canada, France, Germany, Italy and Japan -- said they would take joint action if needed in foreign exchange markets because "disorderly movements ... have adverse effects for economic and financial stability."

A G20 communique along similar lines followed shortly after European markets opened.

The Japanese intervened to restrain their surging currency last week while the Swiss National Bank surprised with a new round of easing as it fought a rapidly rising franc.

FED AHEAD

Investors are now turning their attention to what the Federal Reserve might say at its policy meeting on Tuesday.

Although the Fed's meeting is not expected to produce any immediate change in policy, pressure is now growing on the Fed to try further monetary easing -- dubbed QE3 by the market.

The U.S. central bank completed a second installment of bond buying, or quantitative easing, worth $600 billion on June 30 and the Fed is reinvesting its portfolio as it matures.

"We are probably a little bit closer. But I don't think we're there yet," said Nomura's chief global economist Paul Sheard. "I think the Fed would have to get a little bit more concerned that financial markets were spinning out of control before accepting ... QE3."

(Additional reporting by Laura MacInnis, David Lawder and Mark Felsenthal in Washington, Sarah Marsh and Noah Barkin in Berlin, and Gerard Bon and Paul Taylor in Paris; Editing by Mike Peacock and Clive McKeef)

View the original article here

Analysis: World economy wobbles as markets push policymakers (Reuters)

By Alan Wheatley, Global Economics Correspondent Alan Wheatley, Global Economics Correspondent – 2?hrs?42?mins?ago

LONDON (Reuters) – The message from this week's market rout is crystal-clear: investors have lost confidence in their politicians, who urgently need to do something dramatic to reduce risks to the global economy.

By some measures, the world economy is in better shape to withstand shocks than it was in the aftermath of the failure of investment bank Lehman Brothers nearly three years ago.

Corporate earnings are robust, banks have thicker capital cushions, big emerging markets are still expanding strongly and there has been no repeat of the global liquidity squeeze that sent the dollar soaring in late 2008.

Indeed, after this week's 8.5 percent slump in global equities, a rebound might not be far off. Wall Street initially rose on Friday after the U.S. economy created 117,000 jobs last month, more than expected, only to slide back into the red.

Any relief is likely to be short-lived until politicians get ahead of the markets and show they are tackling the root cause of the malaise -- excessive sovereign debt.

"People have just become spooked by a crass failure of political leadership," said George Magnus, senior economic adviser at UBS in London.

In Magnus's view, the first-half slowdown in U.S. growth -- an important contributor to the current loss of confidence -- was inevitable given how long it will take households to reduce their own debt mountain and rebuild savings.

But he said markets wanted an end to the "political dysfunction" all too evident in the protracted wrangling over the U.S. debt ceiling and the euro zone's inadequate response to the debt crisis gripping the periphery of the 17-member group.

"There are economic solutions to economic problems, but no politicians are stepping up to the plate," he said.

NO URGENCY

The Group of 20 leading economies and the Group of Seven rich nations impressed investors in late 2008 and 2009 by coordinating interest rate cuts and expanding fiscal policy to cushion the post-Lehman freefall in the global economy.

But now, deficit-spending is the perceived problem, not the solution, in both the United States and the euro zone, while interest rates are already close to zero. With little ammunition left in the armory, governments are displaying concern but not enough urgency for the likes of impatient investors.

"There is probably no consensus within the G7 on how to address this," said a source in Japan familiar with G7 negotiations. "Each country is too busy with their own problems to talk about cooperation."

Market mayhem leading to weaker growth in the rich world would naturally be negative for emerging economies.

Jun Ma, an economist with Deutsche Bank in Hong Kong, estimated that a downward revision of 1 percentage point to growth in the United States and the European Union would trim Chinese growth by 1 percentage point, too.

So what happens next?

In the United States, with budget policy now effectively off limits until after the November 2012 presidential election, some analysts believe the Federal Reserve will eventually embark on a third round of large-scale asset purchases, dubbed quantitative easing (QE), if unemployment remains too high for comfort.

The unemployment rate dipped to 9.1 percent from 9.2 in July, but that was because discouraged job-seekers gave up the hunt for work.

"With fiscal policy close to exhaustion and any remaining scope for flexibility apparently compromised by the recent bipartisan agreement on the debt ceiling, the responsibility for providing any additional support to the U.S. economy rests very much with the Fed," said Russell Jones, an economist with Westpac in Sydney.

In a note to clients, Jones said it was probably too early for the Fed to announce a full programme of QE at its policy-setting meeting next week.

But he said the central bank could reinforce its easy policy stance in the interim by taking steps to anchor long-term interest rates in order to spur investment and spending.

COMMON EURO ZONE BONDS TO COME?

As for the euro zone, heavy selling this week of Spanish and Italian bonds is raising pressure on European leaders to massively expand the bloc's emergency financial rescue fund.

Currently at 440 billion euros, it would need to be doubled or tripled to cover economies as big as Italy and Spain, whose cost of borrowing hit fresh euro lifetime highs on Friday. The two countries' 10-year bonds were yielding about 4 percentage points more than those of Germany, the euro zone benchmark.

Magnus at UBS said that, apart from expanding the fund, the issuance of common euro zone bonds was a minimum requirement if political leaders wanted to end the crisis once and for all.

European Economic and Monetary Affairs Commissioner Olli Rehn said on Friday officials would look at longer-term options, including the idea of euro zone bonds, and would present a report after the summer.

But big powers Germany and France have hitherto opposed such a radical step, arguing that it would sap fiscal discipline and raise their own borrowing costs, alienating voters.

But Philip Whyte, a senior research fellow at the Center for European Reform in London, said it was illusory to believe that Italy -- the latest target of uneasy investors -- could restore confidence by its own reform commitments alone.

"The fate of Italy - and, by extension, the euro zone - is likely to be determined as much as by decisions in Berlin and Brussels as by those in Rome. It is becoming harder to see how the polarization of yields within the euro zone can be reversed unless European leaders adopt a common Eurobond," he said in a note.

The political implications of such a development would be momentous. But it would not be the first time that muscular markets have forced policy makers to do their bidding.

"As Lenin once said, 'there are decades when nothing happens, and there are weeks when decades happen'. We fear that the current unraveling in Europe means that we might be in the latter category," GaveKal Dragonomics, a research outfit based in Hong Kong, said in a report.

(Additional reporting by Leika Kihara in Tokyo, editing by Mike Peacock)

View the original article here

Obama seals US austerity bill, but markets anxious (AFP)

WASHINGTON (AFP) – The US debt mountain undermined financial markets Wednesday, even after President Barack Obama signed an emergency austerity bill which averted a disastrous debt default.

Major rating agencies said they were keeping a watchful eye on the ability of the United States to cope with its debt, after Obama said Tuesday the contentious plan was "just the first step" on a long road to economic recovery.

But in a sign that the economic headaches were far from over for Washington, Chinese rating agency Dagong said it had downgraded the US credit rating after the debt ceiling for the world's biggest economy was raised.

Global stocks fell under the twin pressures of lingering concern about the long-term health of the US economy, and a sharp resurgence of the debt crisis in the eurozone despite a package of emergency measures two weeks ago.

In Asia, Tokyo fell 2.11 percent, Sydney lost 2.27 percent and Seoul gave up 2.59 percent. In midday European trade, London's benchmark FTSE 100 index shed 0.88 percent, Frankfurt lost 0.84 percent and Paris fell 0.43 percent.

The measure sent to Obama by deeply polarized lawmakers for his signature lifts cash-strapped Washington's $14.3 trillion debt limit by up to $2.4 trillion while cutting at least $2.1 trillion in government spending over 10 years, a step forecast to drag down already sluggish US growth.

"It's an important first step to ensuring that, as a nation, we live within our means," Obama said in the White House Rose Garden. "This is, however, just the first step."

Obama spoke after the US Senate voted 74-26 to pass the measure -- which cleared the House of Representatives by an overwhelming 269-161 margin on Monday -- with just hours to spare before a midnight deadline that could have triggered a first-ever US default on its debt payments.

"Slowing down the big-government freight train from its current trajectory will give us the time we need to work toward a real solution," said Republican Senate Minority Leader Mitch McConnell.

Congressional approval paid immediate dividends as the IMF applauded the deal and the Fitch and Moody's ratings agencies said the last-minute compromise would spare Washington from losing its sterling triple-A debt rating.

A downgrade would have likely led to a spike in US interest rates, hitting consumer and business spending. It would have severely damaged credibility in the US economy and sent shockwaves around global financial markets.

Moody's, which had warned of a possible downgrade in July due to concern that the government could be forced to default, added a "negative outlook" on the grade, saying a historic downgrade could still come if fiscal discipline weakens or economic growth deteriorates significantly.

And Fitch said it would keep a close eye on the country's long-term finances and pressed for "a credible multi-year deficit reduction plan" if Washington is to stay in the elite club of healthy, low-risk debtor economies.

Dagong meanwhile lashed out at its foreign rivals for not downgrading the US credit rating as it had done -- from A+ to A with a negative outlook -- and said the deal did not guarantee the "safety and interest" of creditors.

China's state Xinhua news agency also warned the compromise had "failed to defuse Washington's debt bomb for good," and mocked the drawn-out negotiations between Republicans and Democrats as a "madcap farce of brinkmanship."

China's central bank welcomed the deal but said it would continue to diversify its foreign currency investments.

International Monetary Fund chief Christine Lagarde applauded the debt deal as "good for both the US and global economy" but pushed US leaders to craft a plan to put public finances "on a sustainable path."

Obama's 2012 reelection bid will turn on voters' perception of his handling of the US economy, which has labored under historically high unemployment above nine percent as it struggles to recover from the global meltdown of 2008.

Republicans have promised the spending cuts will create jobs, but top Wall Street economists have warned the austerity measures will actually be a drag on sluggish US growth even as government stimulus measures run out.

The overall shift from priming the US economy to government belt-tightening is expected to reduce US growth next year by about 1.5 percentage points, according to JPMorgan Chase economists.

The vote came as the US Commerce Department reported that US consumer spending, the economy's key driver, fell 0.2 percent in June relative to May, while personal income was basically stagnant, with just a 0.1 percent increase.

US stocks on Tuesday plunged more than two percent, focusing on dismal economic numbers and the prospect of no more government spending to boost the economy.

The new law calls for more than $900 billion in cuts over the next 10 years -- $350 billion of it in defense -- and creates a special congressional committee tasked with coming up with another $1.5 trillion in cuts to report by November 23, with Congress voting by December 23.

View the original article here

Italy political consensus helps calm markets (Reuters)

ROME (Reuters) – A quick agreement by Italy's government and opposition to pass a closely watched austerity package helped calm markets on Wednesday, but there were calls for further steps to reductions in the deficit.

Facing a market rout after stocks plunged and borrowing costs hit record highs on Tuesday, government and opposition parties shelved their differences and agreed to ensure quick approval of a four-year, 40 billion euro austerity plan.

"The market remains nervous, very attentive, but we had an Italian reaction that was remarkably fast on budget austerity," said Deutsche Bank analyst Gilles Moec.

"The growth issue remains, but there was an immediate, patriotic reaction by the Italian political class that has positively impressed investors."

Economy Minister Giulio Tremonti, widely seen as the guarantor of Italian financial stability, said the government's austerity package would be approved by Friday, and he brushed aside rumors that he may step down.

"Hic manebimus optime," he told a meeting of the Italian banking association, borrowing a phrase from the Roman historian Livy meaning: "We will stay here, extremely well."

At the same event, European Central Bank Governing Council member Mario Draghi urged the government to move ahead with further measures to ensure it meets its target of bringing the budget back into balance by 2014.

"The substance of future measures aimed at balancing the budget by 2014 should be defined as rapidly as possible," he said. "This is what markets are looking at above all today."

He also criticized the European policy response to the debt crisis, saying policymakers needed to "bring certainty to the process by which sovereign debt crises are managed" with clearly defined objectives and instruments.

International Monetary Fund economists have urged "decisive implementation" by Italy to cut its huge public debt, noting that the austerity plan was based on optimistic forecasts with measures weighted toward later years.

Market falls on Friday and Monday wiped around 26 billion euros off the FTSE MIB blue-chip index and sent Italian bond yields up to more than 6 percent, the highest since the launch of the euro more than a decade ago.

On Wednesday, the premium investors demand to hold Italian debt rather than safe-haven German bonds narrowed by 11 basis points to 280 basis points -- after hitting a euro lifetime high of 353 basis points at one stage on Tuesday.

The yield on the 10-year BTP bond stood at 5.46 percent, down 13 basis points but still 46 basis points higher than its levels a week ago.

With the BTP spread against German Bunds narrowing, Italian bank shares -- which have born the brunt of the sell-off because of their vast holdings of government paper -- recovered some of the heavy losses they had suffered on Friday and Monday.

However, Goldman Sachs cut its price targets on Italian banks by 12 percent on average due to expected higher funding costs and lower profitability after the recent rise in Italian government bonds.

MARKET TEST LOOMS

A further test of Italy's ability to keep tapping the markets comes on Thursday, when the Treasury offers up to 5 billion euros of long-term BTP bonds, and markets are waiting nervously to see how the auction succeeds.

If Italy, the third-largest economy in the euro zone, were to share the same fate as Greece or Ireland, consequences would be incalculable. Much too big to bail out, a severe crisis could call the future of the entire euro area into question.

Ratings agency Fitch said on Wednesday it expected the government to succeed in cutting the deficit and said the market turmoil did not reflect Italy's fundamentals.

"The sharp rise in Italian and other euro zone government bond yields in recent weeks reflect a crisis of market confidence in the European policy response to the euro zone debt crisis rather than deteriorating sovereign credit fundamentals," Fitch said in a statement.

Italy has a public debt equivalent to around 120 percent of gross domestic product, second only to Greece in the euro zone and compounded by one of the world's most anemic growth rates.

Tight spending controls, a conservative banking system and a high rate of private savings have helped shield it from the worst of the euro zone debt crisis, but the sell-off this week is a reminder of its potential vulnerability.

A senior Bank of Italy official said the impact of the recent surge in yields was limited in the short term but would be considerable if it persisted -- adding around 3 billion euros to government borrowing costs in the first year and more later.

"If these kind of levels persist, the burden for public finances would be severe," Ignazio Visco, deputy director general of the Italian central bank, told a Senate hearing.

(Additional reporting by Giuseppe Fonte, Michel Rose, Valentina Za, Nigel Tutt, Luca Trogni and Elvira Pollina in Milan; Writing by Silvia Aloisi and James Mackenzie; Editing by Hugh Lawson)

View the original article here