UPDATE 2-Italy's Monti warns on contagion, hints at ECB role

Thu May 31, 2012 9:22am EDT

* Monti says Italy massively exposed to contagion risk

* Says markets failing to take into account Italy's reforms

* Monti hints ECB should resume bond buying programme

By Robin Emmott and Jan Strupczewski

BRUSSELS, May 31 (Reuters) - Italy is hugely exposed to the risk of contagion from the debt turmoil in the euro zone, its prime minister said on Thursday, suggesting the European Central Bank might take action to help cool borrowing costs.

Mario Monti, a respected former European commissioner who took over the premiership in November to enact tough austerity measures, expressed frustration at borrowing costs that have risen for Italy since mid-March despite a 2012 budget deficit forecast at well below the EU average.

"It is obviously a difficult place to be in, when you have a country displaying massive and concentrated efforts of consolidation and structural reforms, which are obviously politically and socially costly, and sees its position threatened by huge possibilities of contagion," Monti said.

"Contagion is there because of the overall weakness of the system rather than for the specific weakness of my country," Monti told a conference in Brussels via videolink from Italy.

On Wednesday, Italian benchmark yields broke above the 6 percent danger level as investors demanded higher returns to buy five- and ten-year debt at an auction tainted by escalating concerns about the banking system in Spain.

Equivalent Spanish yields have risen close to the 7 percent level at which Ireland and Portugal were forced to seek international bailouts.

ECB BOND-BUYING?

Given the rising yields, Monti called on the ECB to step up its efforts to ensure stability in the euro zone and appeared to suggest that the bank should buy Italian bonds to bring the spreads down, us i ng language that echoed that of the bank.

"I believe that the ECB should consider within the realm of its responsibility the integrity of the euro and equally, to ensure financial stability," he said.

"The functioning of the transmission mechanism of monetary policy could be put into question if the spreads between various countries become disconnected, as they have become recently, from the reality of policymaking in different countries."

The ECB, which cannot directly finance governments, used a similar argument to justify its purchases of Italian and Spanish bonds on the secondary market last year.

The bank argued that market gyrations impede the transmission of the central bank's monetary policy decisions that are aimed at underpinning stable prices and a stable European economy.

In private, officials say Spanish Prime Minister Mariano Rajoy has been pressing Brussels and Berlin for the ECB to buy Spanish sovereign debt too.

Monti also warned of a popular backlash if investors demanded countries embark on deeper fiscal cuts beyond what was already been undertaken.

"I know there is a running argument that unless investors put pressure through higher interest rates on governments, governments will not find the determination to do consolidation and structural reforms. Well, it may also be the opposite."

"We have to be mindful of the sustainability of fiscal discipline and the reform process... It is obvious that there is going to be, sooner or later, a backlash against fiscal and structural discipline," Monti said.

FILED UNDER: