(Changes "deficit" to "debt" in paragraph 3)
By Silvia Aloisi and Francesca Landini
MILAN, April 26 (Reuters) - Italian banks face a tougher task than their Spanish peers as both come under political pressure to buy domestic government bonds to offset reduced demand from foreign investors, posing risks to Italy's attempts to refinance its borrowings.
While Spain's struggle to reduce its debt pile has been unsettling financial markets in recent days, its banks are in a better position to step in and help with purchases of government bonds than their counterparts in Italy.
Not only does the scale of Italy's outstanding public debt - nearly three times that of Spain - make the challenge harder for its banks, but Italy has completed a lower proportion of its annual debt issuance than Spain. Its banks also took less than Spanish peers of the cheap funds recently made available by the European Central Bank which could be used to buy bonds.
"Italian banks are now under unprecedented pressure to pick up the slack," said Nicholas Spiro of Spiro Sovereign Strategy.
"One of the key factors to watch in Italy in the coming weeks and months is the willingness of its banks to support their sovereign in its hour of need."
While banks are not obliged to purchase domestic government bonds, they have traditionally been big buyers and they are now coming under huge political pressure to keep doing so in Italy and Spain.
So far they have stepped up to the plate, in part because of the high interest rates they can earn on the bonds. But that may not always be the case, as when investors have fretted about the ability of Italy and Spain to rein in their debts, domestic bank shares have been hit hard because of their exposure to government bonds.
THE TASK AHEAD
The International Monetary Fund estimates Italian lenders will have to buy 223 billion euros in domestic government bonds this year - representing about 9 percent of their assets.
The forecast assumes that the foreign investors' share of Italian debt will not recover after falling to 37 percent in the third quarter of 2011 from 42 percent at the end of 2009.
In Spain, where the share dropped to 38 percent from 51 percent over the same period, the IMF expects lenders to buy 135 billion euros of government paper, or 4 percent of their assets.
The sheer size of Italy's 1.9 trillion euros outstanding public debt makes the task more daunting for Italian lenders.
Additionally, Italy has completed around 40 percent of its gross debt issuance target of around 440 billion euros for this year, compared to about half for Spain.
Economists also estimate that Spanish banks, which took on more cheap three-year ECB funds than their Italian peers, have more liquidity available to support sovereign debt and fund their own redemptions.
"We remain cautious, but increasingly on Italy rather than Spain," Helen Haworth, head of European interest rate strategy at Credit Suisse, said in a report this week. "Italy... has considerable supply requirements which it is less clear that the domestics will be able to support."
Italian banks have already partly obliged.
Bank of Italy data show they used a large portion of cheap three-year loans by the ECB to buy 58 billion euros of government paper in the first two months of the year.
That brings their total government debt holdings to an all-time high of 274 billion euros and does not include the full effect of the second ECB liquidity injection on Feb. 29.
Banks are reluctant to say how many government bonds they have bought. But a source with direct knowledge of the numbers said Italy's top five lenders - Intesa Sanpaolo, UniCredit, Monte dei Paschi, Banco Popolare and UBI - were behind just under half of the purchases in January and February. The rest was bought by smaller banks.
The source said foreign investors were buying Italian short maturities, but still divesting from longer-term bonds.
"This trend is worrying if foreigners don't come back in the coming months," the source said.
J.P. Morgan analysts estimate Italian banks have another 60 billion euros of net liquidity in ECB funds to use to meet potential funding needs of 164 billion euros in the second-to-fourth quarter of the year.
That compares with 90 billion of net ECB funds available for Spanish banks, whose potential funding needs for the rest of the year total 146 billion euros, although these could increase substantially in case of continued deposit outflows.
"The conclusion is that Italy is more vulnerable, especially if non-domestic investors or non-bank domestic investors are unwilling to roll over their maturing debt," J.P. Morgan analysts said in a report.
Italian banks may need to make up for 52 billion euros of maturing government debt held by foreign investors, they said.
For Italian banks, loading up on government debt purchases was partly the result of moral suasion by Prime Minister Mario Monti, who has encouraged lenders to buy domestic bonds. In Spain, too, there has been consistent talk of pressure on domestic banks to support its bond auctions.
But buying bonds also made economic sense as banks used lucrative carry trades between the 1 percent interest rate paid to the ECB and higher bond yields to revive flagging profits.
Barclays estimated this week carry trades will lift UBI Banca's earning per share by 25 percent, for example.
Italian government bond yields averaged 5.7 percent in January and 4.6 percent in February, Bank of Italy data show. By contrast, the average interest rate on banks' loans to families and non-financial companies hovered just under 4.2 percent.
Yet the banks' increased exposure to sovereign debt is making investors jittery as bond yields are back on the rise on fears that Spain's deficit woes could spread to Italy.
The tight link between Italian banks and sovereign debt sparked a massive sell-off in their stocks last year.
It also swelled a collective capital shortfall of 15 billion euros identified by the European Banking Authority for Italy's top five banks, as the watchdog required lenders to mark-to-market their government bond holdings.
Over the past month, banks got a reminder of how their bond purchases can turn into a boomerang when market sentiment sours.
Intesa's shares lost 24 percent, UniCredit fell 30 percent, Monte dei Paschi 33 percent as the yield spread between 10-year Italian and German bonds hovered around 400 basis points. (Additional reporting by Valentina Za in Milan and Nigel Davies in Madrid; Editing by Mark Potter)