ECB action prospects underpin Italian bond auction

MILAN/BEIJING (Reuters) - A successful Italian bond auction on Thursday pointed to growing confidence among investors that the European Central Bank will live up to its words and take measures to change the course of the currency bloc's debt crisis.

In Beijing, German Chancellor Angela Merkel appeared to temper China's fears about the damage the crisis could wreak on the world economy, enough to elicit an undertaking that China would, under certain conditions, buy more euro zone bonds.

Since ECB President Mario Draghi vowed a month ago to do whatever it takes to save the euro, Spanish and Italian bond yields have fallen markedly, particularly for shorter-dated maturities. Now he has to follow through.

At a policy meeting next week Draghi is expected to reveal the ECB's terms of engagement for intervening in the bond market, reconciling a resistant German Bundesbank to the plan while avoiding conditions that will scupper its effectiveness.

Credible ECB action to lower Italian and Spanish borrowing costs would buy the two countries time to reduce their debt and push through economic reforms to boost growth potential.

Italy sold 7.29 billion euros of debt at its first auction in a month, and shifted the maximum targeted amount of a new 10-year bond at a yield well under its 6 percent pain threshold.

"It's a lower yield than the previous one," said Elisabeth Afseth, fixed-income analyst at Investec in London. "I think it is very much to do with the ECB, and if we hadn't had that, I suspect that both Spanish and Italian yields would have been considerably wider than where they are."

Chinese Premier Wen Jiabao said a briefing by Merkel assuaged his concerns slightly, but warned that no quick resolution for the crisis was in sight.

"The main worries are two-fold: first is whether Greece will leave the euro zone. The second is whether Italy and Spain will take comprehensive rescue measures," Wen said.

"After I heard her views, it increased my confidence. But I must honestly say, the implementation of these measures won't be completely smooth," Wen said, before adding that China could be prepared to buy more EU government bonds after evaluating the prevailing risks.

His remarks helped lift the euro, although Beijing has made similar noises on bond buying before with little result.

Draghi has said the ECB will buy Spanish and Italian bonds if called upon but that any recipient country must first seek help from the euro zone's rescue fund, to which conditions will be attached.

Merkel has signalled her backing for Draghi's strategy despite warnings from Bundesbank chief Jens Weidmann that to do so would risk letting indebted euro zone governments off the hook for the austerity measures and reforms they need to implement.

Sources say Weidmann is short of allies within the ECB and could not block the scheme, but if his concerns are not met, ongoing Bundesbank criticism could undermine it.

Draghi has cancelled a visit to a gathering of top central bankers in Jackson Hole, Wyoming, suggesting he has his hands full knocking up a viable plan.

"We have to see what the ECB can do by its statutes, but we also have to tighten controls because it cannot be that this leads to moral hazard," Austrian Finance Minister Mario Fekter said in an interview with Reuters.

Draghi said on Wednesday the ECB must employ "exceptional measures" at times to fulfil its mandate of delivering stable prices, his argument being that official euro zone interest rates are at record lows yet borrowing costs in some of its members are sky high, so monetary policy is not working as it should.

SHUTTLE DIPLOMACY

September is shaping up to be a crunch month, with the ECB policy meeting on September 6, followed by a German court ruling on September 12 on whether the bloc's permanent ESM rescue fund is compatible with Germany's constitution, and a meeting of EU finance ministers two days after that, at which further aid for Spain is expected to be discussed.

A make-or-break report from EU/IMF/ECB inspectors on the state of Greece's finances and whether it can meet its bailout targets is due in late September or early October.

The ECB is unlikely to intervene at least until it knows the ESM is operational, sources say.

Spain remains at the sharp end of the debt crisis, having switched tack to signal it could seek some form of sovereign bailout. If it sought help from the euro zone's rescue funds to lower its borrowing costs, the ECB would be expected to pile in behind.

Prime Minister Mariano Rajoy has said he would not seek any further help, to add to a bailout of Spanish banks worth up to 100 billion euros, until the ECB's strategy is clear.

But with Spain's northeastern region of Catalonia calling for government help this week and recession deepening, some form of outside assistance is increasingly likely.

Rajoy will meet French President Francois Hollande later in the day, and Merkel will fly to Madrid next week.

(Additional reporting by Michael Martina in Beijing, Mike Shields in Vienna. Writing by Mike Peacock; Editing by Will Waterman)

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