UPDATE 2-Italy debt costs rise as downgrade pressures government
* One-year debt yields highest since March, but demand strong
* Auction follows S&P Tuesday downgrade to BBB from BBB+
* Outlook depends on action of Letta govt
* Govt struggles as Berlusconi verdict looms
MILAN, July 10 (Reuters) - Italy's one-year borrowing costs rose to their highest since March on Wednesday after Standard & Poor's cut its credit rating, a warning to the faltering coalition government as it seeks to revive the economy.
But the downgrade had a mild impact on Wednesday's auction, at which the Treasury paid a yield of 1.078 percent to sell 7 billion euros ($8.95 billion) of one-year bills, up from 0.96 percent at a similar sale one month ago.
Yields are still far lower than a peak of more than 6 percent reached in late 2011, at the height of the euro zone debt crisis, and demand remained fairly strong with a bid-to-cover ratio of 1.56, up from 1.49 at mid-June sale.
"The auctions went well, demand was good. The yields did not come in much higher than what we were expecting yesterday before the downgrade," said Unicredit economist Chiara Cremonesi.
On Tuesday, S&P cut Italy's sovereign credit rating to BBB from BBB+, two notches above junk, citing concerns about the economy, which has been stuck in recession since mid-2011.
Yields on outstanding Italian bonds edged higher after the downgrade, which also hit Spanish debt.
Italy's challenge is linked to the effectiveness of the right-left coalition government led by Prime Minister Enrico Letta, which is struggling to overcome its internal divisions.
A coalition meeting on Wednesday fell through when the People of Freedom party pulled out after Tuesday's announcement that its founder, Silvio Berlusconi, faces a final ruling on a tax fraud conviction on July 30 - much earlier than expected.
The party has also proposed suspending work in parliament in light of the looming verdict. If Berlusconi's conviction is upheld, he will be banned from public office for five years.
"Berlusconi's legal woes could yet lead to early elections in Italy," Nicholas Spiro, head of Spiro Sovereign Strategy, said in a note. "The downgrade underscores the severity of Italy's recession ... and the bleak prospects for growth-enhancing structural reforms under the unstable and conflict-ridden Letta government."
S&P said further downgrades were possible if the government fails to keep a tight rein on the deficit and does not undertake badly-needed labour market and other liberalisations.
Those particular reforms are not even on the government's agenda at the moment. Letta tried to turn the ratings cut in his favour late on Tuesday, using it to put pressure on his allies.
"It's proof that the situation is still complex and Italy remains under special observation," Letta said.
Economy Minister Fabrizio Saccomanni on Wednesday criticised the ratings cut, saying it failed to take account of recent government measures to lift growth.
"The decision appears based on a mechanic extrapolation of past data," Saccomanni told a meeting of Italy's banking lobby.
ECB board member Christian Noyer said on Wednesday the downgrade for Italy illustrates a broader, European problem.
"This highlights the need to accelerate the implementation of structural reforms in the whole euro zone," he said.
The Bank of Italy warned that the country cannot afford to lose investor confidence.
Letta has pledged to ease the severe austerity policies pursued by predecessor Mario Monti's technocrat government. But so far he has only been able to postpone payment of a housing tax, introduce some tax breaks for companies that hire unemployed youth, and relaunch some public works projects.
Meanwhile, economic data show that Italy is not pulling out of its slump. Industrial output rose slightly for the first time in four months in May, but fell for a 21st consecutive month from a year earlier, figures published on Wednesday showed.
The euro zone's third-largest economy has been one of the slowest-growing in the world for more than a decade, shackled by a lack of competitiveness, a weak political system and public debt topping 130 percent of gross domestic product.
On Wednesday, Rome also issued 2.5 billion euros of bills maturing on Dec. 19, 2013, at an interest rate of 0.599 percent. These assets, dubbed 'flexible bills', are issued by the Treasury from time to time to cover seasonal liquidity needs.
Italy will return to the primary market on Thursday to sell up to 6.5 billion euros in three- and 30-year bonds and floating rate notes in a triple sale.
Rome, which has frontloaded its funding, has already raised more than 63 percent of its overall borrowing needs for 2013.
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