* Euro zone's largest borrower loses foothold abroad
* Change to derivatives law offers way back in
* Some say eventual return may prove fruitless
By John Geddie
LONDON, June 26 (Reuters) - Italy, the euro zone's biggest debtor, risks missing out on cheap foreign funding unless the Treasury can win approval to use controversial derivatives to protect itself against currency swings.
The euro zone sovereign historically most reliant on foreign borrowing, Italy has let its foreign currency debt fall to its lowest level in over two decades, leading some to question whether it is fully capitalising on a tentative resurgence in international demand for its bonds.
"This is a good opportunity, why not exploit it?" said Cosimo Marasciulo, head of European Government Bonds at Pioneer.
But financial regulation and a steady erosion of Italy's credit rating during the euro debt crisis has ramped up bank charges for the derivatives the country needs to insure against the risk of issuing in non-domestic currencies.
Seeking to reduce these swap charges, the Treasury late last year drafted a law to give the banks it deals with a further layer of cover against the risks involved.
The law, which also applies to interest rate derivatives used to manage the duration of debt portfolios, was to be put before parliament last December but has still not appeared.
Senior bank sources say there is some political resistance to the changes, but a Treasury spokeswoman declined to comment on the matter, adding it was still working on the draft.
One of the reasons the Treasury is dragging its feet may be that the proposed guarantees would probably involve raising billions of euros to hold in reserve against potential derivatives losses - money that an austerity-wearied population might think could be better directed elsewhere.
Besides, Italy has a chequered history with derivatives.
The country was forced to pay Morgan Stanley $3.4 billion when the bank invoked a clause to break a contract in 2011, while its 2014 Budget Law banned its local and regional governments from using derivatives after hundreds of pre-crisis deals turned sour, ending up in court disputes.
Italy has vehemently denied suggestions that, like Greece, it used interest rate derivatives to manipulate its debt dynamics to suit entrance criteria for the euro in 1999.
With consistently higher annual debt issuance than any other member state in the euro era, Italy has made more significant use of foreign funding in the past.
Its slipping foothold abroad runs contrary to the Treasury's commitment to overseas markets.
On its website, the Treasury says its international programme is "instrumental" for its "objectives of diversifying the international investor base... therefore containing its long-term borrowing cost and refinancing risk."
It describes the U.S. bond market - the biggest in the world - as "the main building block" of this programme although it has not issued a dollar bond since September 2010.
When Italy redeems two more of its dollar bonds in January its total stock will be just $12.5 billion (9.2 billion euros) - a tiny fraction of its total debt of over 1.8 trillion euros, which is the highest in its history.
Strategists say some euro zone sovereigns have missed out on considerable savings by not issuing dollar bonds in recent years, as banks were prepared to pay high premiums to access dollars in the cross-currency basis swap market.
Germany and France took advantage of this via government agencies such as development bank KfW and social security fund Cades, respectively, which each year borrow billions of dollars in the bond market and exchange them for euros with their banks.
Countries like Spain and Italy do not have such a sophisticated network of government agencies, but last year the Spanish Teasury issued its first dollar bond since 2009.
Portugal is now pondering a dollar-denominated bond, which would be its first such issue since 2010.
Some analysts, however, say returning to foreign markets should not be a high priority for Italy given the demand at home which has been bolstered by cash injections from the European Central Bank.
The Treasury "is trying to keep a channel open but it is not clear how relevant this channel now is," said Luca Cazzulani, strategist at UniCredit.
But while Italy's borrowing costs over 10 years have fallen from more than 7 percent at the end of 2011 to record lows of 2.7 percent earlier this month, the amount of foreign holdings of its debt have only made a minor recovery compared to its higher-rated peers.
This is why some strategists say Italy's planned return to foreign markets could prove fruitless, for now.
With a credit rating just a couple of notches above junk, Italy may not appeal to ultra-conservative central banks and official institutions which have tended to be the largest buyers of euro zone sovereign paper issued in foreign currencies.
"It might be an issue that even if the theoretical funding cost has become more attractive, you might actually struggle to find the investor base at present," said Anton Heese, co-head of European interest rates strategy at Morgan Stanley. (Graphics by Vincent Flasseur, Editing by Ruth Pitchford)