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Bond market hammers Italy, Spain ponders outside help

By Barry Moody and Elisabeth O'Leary

ROME/MADRID (Reuters) - Italy's borrowing costs soared to their highest levels since Rome joined the euro on Friday, piling pressure on the newly installed government of Mario Monti at the end of a week in which the euro zone crisis tainted even safe haven Germany.

A punishing bond sale, in which Italy was forced to pay a record 6.5 percent for six months paper, came after a disastrous German bond auction earlier in the week and the leaders of France, Germany and Italy failed to make headway in tackling the growing debt crisis.

Amid signs that the euro zone contagion is spreading, indications emerged in Madrid that the People's Party, getting ready to form a government in the coming weeks, may apply for international aid to shore up its finances.

After winning an election this month, the PP under Mariano Rajoy inherits an economy on the verge of recession, a tough 2012 public deficit target, financing costs driven to near unsustainable levels by nervous debt markets and a battered bank sector with billions of euros of troubled assets on its books.

Tuesday's launch by the International Monetary Fund of a credit facility for fiscally responsible countries at risk from the euro zone debt crisis gives it a potential lifeline it may wish to exploit.

"I don't believe the decision has been made ... but it is one of the options on the table, because I've been asked about it. But we need more time and more information on the current state of things," a source close to the PP told Reuters.

Italy's auction on Friday, described by one analyst as "awful," spooked investors further and pushed two-year yields on the secondary market to an eye-watering euro lifetime high of more than 8 percent.

Longer term debt is above a "red line" of 7 percent which forced Portugal, Greece and Ireland into bailouts that Europe could not afford for the much bigger Italian economy.

Spiralling borrowing costs have added to pressure on Monti's government of technocrats, hastily sworn in this month after Prime Minister Silvio Berlusconi was bundled out of office as economic pressures grew.

European Economic and Monetary Affairs Commissioner Olli Rehn threw his backing behind Monti but warned that swift action was needed to contain the escalating euro zone debt crisis.

He dismissed fears that the euro's survival was in question but said the crisis had reached the heart of the single currency.

"This contagion effect has been touching the proximity of the core and even touching the core itself," he told a news conference after meeting Monti in Rome.

"It shows that this is an increasingly systemic phenomenon, which calls for strong financial firewalls in order to contain this contagion and have a counterforce to this market turbulence."

EYES ON ECB

With the European Central Bank coming under increasing pressure to take more effective action, something it and Germany continue to oppose in public, officials suggested one possible scenario that could break the impasse.

A push by euro zone countries toward very close fiscal integration could give the ECB the necessary room for maneuver to dramatically scale up euro zone bond purchases and stabilize markets.

The ECB, which cannot directly finance governments, has been buying Italian and Spanish bonds intermittently on the secondary market since August to try to keep their borrowing costs and contain Europe's sovereign debt problem.

But Italian and Spanish yields have nonetheless reached levels that economists see as unsustainable, raising the possibility that Rome and Madrid will be forced to seek emergency international funding.

"We are not far from a point when the disruption in the markets is so big that monetary policy transmission does not work at all," said one euro zone official involved in shaping the euro zone's policy response to the crisis.

"If the ECB has the assurance that we are moving toward a fiscal union, they could be ready to go all out," he said

Belgium, which had prided itself on being able to stabilize its debt position despite having had no government for the past 18 months, saw its credit rating downgraded.

Political deadlock in Brussels prompted Standard & Poor's to cut Belgium's credit rating to double-A from double-A-plus, citing concerns about funding and market pressures, as the euro zone debt crisis continues to worsen.

"We need a reply that is clear and credible if we are to avoid the worst," Belgium's caretaker prime minister, Yves Leterme, told Belgian television.

The downgrade followed difficulties this week in Belgium's drawn-out attempt to form a government. Elio Di Rupo, leader of the French-speaking Socialists, had been trying to form a government based on a six-party coalition.

But he tendered his resignation on Monday after talks for a 2012 budget - agreement on which is a condition for forming a government - ground to a halt.

Greek, the source of the euro zone's debt crisis, provided another source of dispute.

Investors' worries intensified after reports that Greece was demanding harsh conditions from creditors on a proposed bond swap -- critical to reduce its debt and avoid default.

Banks represented by the Institute of International Finance agreed last month to write off the notional value of their Greek bondholdings by 50 percent to reduce Greece's debt ratio to 120 percent of its gross domestic product by 2020.

But Greece was demanding that its new bonds' net present value -- a measure of the current worth of future cash flows -- be cut to 25 percent, a far harsher measure than the banks had in mind, according to people briefed on the matter.

(Writing by Giles Elgood, editing by Mike Peacock)

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