Italy PM warns policymakers against dividing Europe

ROME/BERLIN (Reuters) - Italy's prime minister urged European policymakers on Friday to beware of dividing the continent with their efforts to fight its debt crisis, warning against a "short-term hunger for rigor" in some countries, in a swipe at Germany.

German Chancellor Angela Merkel gained some respite from domestic pressure for a tougher line in the euro zone crisis when Eurosceptics hostile to more bailouts lost a referendum in her junior coalition partner, the Free Democrats, aimed at blocking a permanent rescue fund.

Merkel -- under pressure from the revered Bundesbank to force debt-saddled euro zone countries to reform and save their way out of crisis with austerity measures -- has led a push for automatic sanctions for deficit "sinners" in the bloc.

This has fed concerns that excessive belt-tightening in southern countries could send their economies into a negative spiral with no prospect of growing out of the crisis, while feeding resentment in the prosperous north.

Italian Prime Minister Mario Monti said Europe's response to the debt crisis "should be wrapped in a long-term sustainable approach, not just to feed short-term hunger for rigor in some countries.

"To help European construction evolve in a way that unites, not divides, we cannot afford that the crisis in the euro zone brings us ... the risk of conflicts between the virtuous North and an allegedly vicious South," he told a conference in Rome.

The head of Italy's largest labor federation CGIL said on Wednesday the country risks a "social explosion" over austerity measures, and unions plan more protests against them.

In Germany, turnout fell short of the necessary quorum of one-third of the FDP's membership, and only 44.2 percent voted for dissident lawmaker Frank Schaeffler's motion against the planned European Stability Mechanism.

A victory for the Eurosceptics could have brought down Merkel's centre-right coalition, but the outcome still left the FDP split, with its public support in tatters.

The euro held steady above $1.30 on Friday and Spanish and Italian bonds rallied even though investors remain nervous of a possible Standard & Poor's credit rating downgrade of several euro zone countries, including AAA-rated France.

BANKS TO SHUN BONDS?

French officials have sought to prepare the public for the likelihood that Paris will lose its top-notch rating for the first time since 1975, playing down the potential setback and focusing attention instead on neighboring Britain.

"The economic situation in Britain today is very worrying, and you'd rather be French than British in economic terms," Finance Minister Francois Baroin said in a radio interview, a day after Bank of France governor Chrisian Noyer said that if ratings agencies were even-handed, Britain deserved to be downgraded before France.

Euro zone officials said the potential downgrade of up to 15 the 17 euro zone countries could raise the cost of borrowing for the region's existing EFSF bailout fund but would not make a big difference to its operations.

The European Central Bank has resisted calls to embark on unlimited purchases of euro zone sovereign bonds to quell the debt crisis, putting the onus back on governments and their financial firewalls.

ECB President Mario Draghi said on Thursday that euro zone governments were on the right track to restore market confidence and the ECB's bond-buy plan was "neither eternal nor infinite".

Draghi also urged banking authorities to ensure that tougher capital rules do not lead to a credit crunch, and encouraged banks not to be shy about taking 32-year liquidity from the ECB.

Yves Mersch, another ECB policymaker, echoed Draghi's concern, saying the whole euro zone faced the risk of recession.

"We are worried about a credit crunch, which could plunge our economies -- including the best ones -- into a recession again," he told German television station ZDF late on Thursday.

The comments came amid growing signs that banks are unlikely to come to the aid of debt-choked euro zone countries by using cheap money lent by the ECB to buy more sovereign bonds.

With euro zone governments needing to sell almost 80 billion euros of fresh debt in January alone, the stand-off between policymakers and banks could turn the slow-burning debt crisis into a full-scale conflagration in the New Year.

The chief executive of UniCredit, one of Italy's two biggest banks, said this week using ECB money to buy government debt "wouldn't be logical".

In Italy, employers' lobby Confindustria on Thursday slashed its 2012 gross domestic product (GDP) forecast, projecting a contraction of 1.6 percent from growth of 0.2 percent seen previously and said even that estimate was optimistic and based on a gradual easing of the euro zone debt crisis.

Monti's government easily won a parliamentary vote of confidence on Friday for a package of tax hikes, spending cuts and pension reform aimed at meeting Italy's goal of balancing its budget in 2013. The measure goes to the Senate next week.

In Greece, where the debt crisis began two years ago, a senior official of the EU/IMF troika team negotiating terms for a second bailout package said there was no guarantee that talks on the private sector's contribution would lead to a voluntary deal involving the bulk of its creditors.

Agreement has been held up by wrangling over issues ranging from the credit status and interest coupons on the new bonds to legal guarantees to be offered by the official sector. Another key question is how many sign up to a private sector debt swap.

Failure to secure agreement could force a disorderly default which might in turn trigger a wider emergency across the euro zone as it struggles to cope with the escalating crisis.

Asked if there was a risk of a disorderly Greek default, the troika official said: "Our objective is still to have a voluntary operation. If you ask me: is there a guarantee that there will be a voluntary operation? Of course there can never be a guarantee."

Negotiations between representatives of banks and insurers, the Greek government and the EU, ECB and IMF continued in Paris on Friday after Deutsche Bank Chief Executive Josef Ackermann, who chairs the lobby group representing the investors, said the talks had run into the ground over the size of the "haircut".

(Additional reporting by Steve Scherer in Rome, Annika Breidthardt in Berlin, Gareth Gore, Natsuko Waki, Kirsten Donovan and Ana Nicolaci da Costa in London, Ingrid Melander in Athens; Writing by Paul Carrel and Paul Taylor; Editing by Jeremy Gaunt)