Italy downgraded, IMF says Europe behind the curve

A woman walks past Milan Stock Exchange July 12, 2011.

ROME/ATHENS (Reuters) - Standard & Poor's cut Italy's credit rating on Tuesday in a surprise move that increased strains on the debt-stressed euro zone, and the International Monetary Fund said Europe's leaders were failing to act decisively enough to resolve the crisis.

Analysts said the one-notch downgrade, citing poor growth prospects and political instability, was ominous for the global economy and would add to mounting strains on European banks as talks to avoid a Greek default drag on.

S&P's rating is now three notches below rival agency Moody's, putting Italy below Slovakia and on a par with Malta.

"There is a wide perception that policy-makers are one step behind markets," IMF chief economist Olivier Blanchard told a news conference after the IMF warned that both Europe and the United States could slip back into recession.

"Europe must get its act together," he said.

Another IMF official said talk of splintering the euro zone was "crazy."

Italy's downgrade overshadowed glimmers of progress in Greece's negotiations with international lenders to avoid running out of money within weeks, and news that Brazil was willing to pump in $10 billion through the IMF to aid Europe.

A Greek Finance Ministry official said on Tuesday the government has agreed to front-load austerity measures and is close to securing a deal with its international lenders.

But investors had larger problems on their minds.

"Italy is a much bigger deal than Greece," said Kathy Lien, director of currency research at GFT in New York.

DEBT ITALIAN STYLE

Italian Prime Minister Silvio Berlusconi said S&P's decision did not reflect reality and his government was already preparing measures to spur growth.

Under mounting pressure to cut its debt, the government pushed a 59.8-billion-euro austerity plan through parliament last week, pledging a balanced budget by 2013.

But there has been little confidence that the much revised package of tax hikes and spending cuts, agreed only after repeated chopping and changing, will do anything to address Italy's underlying problem of stagnant growth.

"We believe the reduced pace of Italy's economic activity to date will make the government's revised fiscal targets difficult to achieve," S&P said in a statement.

Europe has come under increasing global pressure to resolve a crisis that has seen numerous sovereign rating downgrades and financial rescues for Greece, Portugal and Ireland.

A bailout of Italy would overwhelm euro-zone resources.

Analysts said the crisis should be addressed by policy-makers starting with the U.S. Federal Reserve Board meeting on Tuesday and Wednesday, and the G20 and IMF/World Bank in Washington later in the week.

"I think it's going to necessitate some sort of action by the G20 this weekend," Lien said.

That leaves plenty of scope for disappointment.

The United States has heaped pressure on euro-zone leaders to act more decisively, but received a decidedly cool response.

An EU document, obtained by Reuters, showed the bloc will call on China to boost domestic demand, and on the United States and Japan to tackle their public deficits as part of global efforts to rebalance growth, suggesting there will be no meeting of minds in Washington.

A government official in Berlin said Germany would stress the importance of consolidating public finances, a rebuff to U.S. calls for Europe's stronger economies to provide more stimulus, which the official branded "not helpful."

BANK STRESS PILES UP

In the latest signs of stress on the banking system due to the debt crisis, sources said the Bank of China had stopped foreign-exchange forwards and swaps trading with top French banks Societe Generale, BNP Paribas and Credit Agricole as well as Switzerland's UBS.

The move by a bank that is a big market-maker for China's onshore foreign-exchange market reflected a broad unease about counterparty risk in the euro-zone crisis, three sources with direct knowledge of the matter said.

French banks are among the most heavily exposed to Greece, which ratings agency Fitch said on Tuesday was likely to default but stay in the euro zone.

A Paris-based source said German engineering giant Siemens withdrew an unknown amount in deposits from SocGen in July, although that was because of underperformance and not fears over the French bank's financial health.

And in a sign of growing funding troubles, commercial banks took 201 billion euros in the European Central Bank's main seven-day refinancing operation on Tuesday, the highest volume since early February.

The head of the European Central Bank, Jean-Claude Trichet, urged in a newspaper interview that European banks strengthen their balance sheets to improve their resistance to the crisis.

Finnish Prime Minister Jyrki Katainen said in a television interview: "If a euro-area country were to end up in very bad shape, it would impact banks' health. If one or more significant banks were in bad shape, it would spread irrational panic to the whole banking market, which could cause good banks to suffer.

"We have both country risk and banking market collapse risk, but we are working every day to avoid these risks and to create as much stability as possible," he told MTV3.

GREEK DRAMA DRAGS ON

A Greek finance ministry official said Athens was close to a deal with European and IMF inspectors on extra austerity measures to secure the release of an 8-billion-euro loan installment vital to pay state salaries and pensions next month.

But a source in the troika of lenders said no agreement could be clinched until their top officials returned to Athens. They have so far conducted talks by telephone to raise pressure on Greece to comply.

The international lenders are demanding public-sector job cuts, higher heating oil tax and more pension cuts to close a gap in this year's budget deficit due to a deeper-than-forecast recession and poor revenue collection.

Finance Minister Evangelos Venizelos held what Greece termed "productive and substantive" talks by phone with senior EU and IMF officials on Monday after promising as much austerity as necessary to win a vital next tranche of aid.

Experts were thrashing out details all day on Tuesday and Venizelos was to confer again with the EU/IMF mission chiefs by telephone at 1700 GMT, his office said.

Italy, the euro zone's third-largest economy, has been dragged to the center of the debt crisis over the past three months as concern has grown about its ability to handle debt equal to 120 percent of GDP.

S&P cut its ratings on Italy to A/A-1 from A+/A-1+ and kept its outlook negative. The move was a surprise because the market had thought Moody's was more likely to downgrade Italy first. Moody's said last week it would take another month to decide on its action.

Brazil could make up to $10 billion of its own money available to help Europe through various channels, including the IMF, or by making bond purchases, and has urged other large emerging market countries to provide similar support, an official told Reuters.

It has previously said it was in talks with the four other big emerging economies or so-called BRICS -- Russia, India, China and South Africa -- to make coordinated purchases of bonds of euro zone countries.

Brazil's contribution by itself would almost certainly be too small to make a major difference to Europe's debt and it will have a tough time convincing its risk-averse fellow BRICs to bankroll a European rescue -- no matter how the aid is structured.

(Reporting by Reuters bureaus; Writing by Raju Gopalakrishnan and Paul Taylor; Editing by Catherine Evans)