* One-year debt yields highest since March, but demand
* Auction follows S&P Tuesday downgrade to BBB from BBB+
* Outlook depends on action of Letta govt
* Govt struggles as Berlusconi verdict looms
By Stephen Jewkes
MILAN, July 10 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
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.