By Steve Scherer and Jan Strupczewski
ROME/BRUSSELS (Reuters) - Technocrat Prime Minister Mario Monti appealed to Italy's politicians on Wednesday to back his tough economic medicine to avoid Rome becoming the next victim of the euro debt crisis, after a bailout for Spain's banks failed to calm markets.
Monti, whose approval rating has slumped as new taxes take hold and recession bites, told parliament in Rome: "We should use these new difficulties to double our efforts both on the European front and within Italian politics."
Four days after EU partners lent Spain's banks up to 100 billion euros ($125 billion), Madrid's sovereign debt rating was cut by three notches to Baa3 from A3 by Moody's, which noted the rescue plan for the banks will add to government debt. Citing Madrid's own difficulties borrowing in the markets and weak economy, the agency said it could cut the rating further.
A Reuters poll of economists found that 35 out of 59 think Spain will follow Greece, Ireland and Portugal in needing a full state bailout within 12 months.
Still, 37 out of 59 expected the currency union to survive in its current form for at least another year - albeit with a very weak economy given the obstacles Europe's leaders face in trying to resolve the two-year old sovereign debt crisis.
"It's not a question of whether the crisis will get worse before it gets better, but rather it must get worse before it gets better," said Richard McGuire, senior fixed income strategist at Rabobank International in London.
In a sign of the concern growing at the White House that a failure in Europe to find the road back to growth might bar Barack Obama's path to re-election in November, the U.S. president called EU Council head Herman Van Rompuy to discuss the financial crisis, a spokesman in Brussels said.
U.S. Treasury Secretary Timothy Geithner said later that the European leaders maintained a strong political commitment to making the euro work.
Spanish Prime Minister Mariano Rajoy, speaking in Madrid, said that while each country had to take its own measures to clean up public finances and reform the economy, only closer European integration could solve the crisis.
"This situation can only be fixed by doing what must be done at home and with much more Europe and much more integration," the Spanish leader said. "The most urgent thing is that there should be more clarity on the euro zone."
GERMANY BACKS MONTI
European Union paymaster Germany urged Italians to implement Monti's painful fiscal and economic reforms to stay out of the danger zone: "If Italy continues along Monti's path there will be no risks," German Finance Minister Wolfgang Schaeuble said in an interview with La Stampa daily when asked whether Rome was next in the markets' firing line.
Monti met Schaeuble in Berlin later and said Italy was preparing to sell state assets but did not need a new austerity program to meet its budget goals.
In remarks aimed at those in Rome and other capitals who are wary of German calls for closer harmony among euro zone governments on their budgets, Monti, a former EU commissioner, said it was better to "share sovereignty" in a union that to be subjected willy-nilly to decisions made by bigger powers.
Highlighting the peril for Italy, the euro zone's third biggest economy had to pay nearly 4 percent to sell one-year treasury bills at auction on Wednesday, a six-month high, due to fears about its ability to keep servicing its debt mountain.
Italy's 1.9 trillion euro ($2.4 trillion) public debt is equivalent to 120 percent of gross domestic product, a ratio second only to Greece. A month ago, Rome had paid just 2.34 percent on one-year paper.
Schaeuble said Italy had made huge progress under Monti's government, which has taken austerity measures and launched pension and labor market reforms since replacing Silvio Berlusconi's scandal-plagued administration in November.
"This is acknowledged everywhere in Europe and by the markets," the German minister said. "I can only hope that political forces in the Italian parliament and public opinion continue to decisively back him, because the road towards a return to sustainable growth through structural reforms, improved competitiveness and a lower deficit is the right one."
Monti, whose popularity has slumped after an initial honeymoon, met the leaders of the parties backing him in parliament on Tuesday and urged them to give their unified support to help Italy through market turmoil.
Markets calmed slightly on Wednesday due to expectations of further euro zone policy action to tackle the debt crisis, but investors remain wary ahead of a general election in Greece on Sunday that could lead to the country leaving the euro area.
Greeks are pulling their cash out of the banks and stocking up with food ahead of the cliffhanger election that will have ramifications far beyond Athens, potentially threatening economic and monetary stability in Europe.
Bankers say up to 800 million euros are leaving major banks daily and retailers report some of the money is being used to buy pasta and canned goods, as fears of returning to the drachma are fanned by rumors that a radical leftist leader may win the vote.
The last published opinion polls showed the conservative New Democracy party, which backs the 130 billion euro bailout that is keeping Greece afloat, running neck and neck with the leftist anti-austerity SYRIZA party, which wants to tear up the deal.
EU officials have hinted that they would be willing to consider giving Greece more time to achieve its fiscal targets, easing the pace of austerity, provided a new government accepted the main conditions of its international assistance program.
The possibility of a victory for the radical leftists has driven neighboring Cyprus to the brink due to its banks' heavy exposure to Greece.
The country's central bank governor said on Wednesday Cyprus was looking to Europe and elsewhere for the best bailout terms, and local media reported Nicosia would spurn EU partners and borrow from Russia or China.
"If we eventually apply, because it is not a given that we will apply (and) there are also other options, we will seek the best terms for the economy," Panicos Dimitriades told reporters. He declined to comment on the timing.
European Union leaders plan to call for much stronger banking and fiscal integration and enhanced governance in the euro zone at a summit later this month, but draft conclusions obtained by Reuters left the details vague.
"Recent developments have demonstrated the need to take the EMU (Economic and Monetary Union) to a further stage," said the draft due to be discussed by EU ambassadors on Thursday.
"The new stage will build on deeper policy integration and coordination. There is a need for more specific building blocks centered around a much stronger banking and fiscal integration, underpinned by enhanced euro governance," it said.
The document said leaders of the 17-member currency area would hold a separate meeting right after the 27-nation EU summit to discuss a timetable for those reforms.
Monti told parliament in Rome the EU needed a growth plan boosting investment and eventually joint euro bonds to stem the spread of the crisis.
Spanish 10-year bond yields fell slightly after hitting a euro lifetime record of 6.86 percent on Tuesday, as investors weighed the risk that the Spanish state may eventually need a full bailout if the bank rescue fails to stop the rot.
Germany's Schaeuble sought to quash such talk, telling La Stampa: "Spain too is on the right path. It does not need an aid program. It has a specific problem with its banking sector and I am sure it will solve it."
Market nerves over the worsening euro zone crisis are also beginning to affect Germany, which has so far seen its borrowing costs fall to negative levels in real terms because it has been seen as a safe haven.
German bond prices tumbled on Wednesday, extending a steep fall seen the previous day, though traders expect them eventually to rebound with markets still fixated on Spain's elevated bond yields and the Greek election risk.
(Additional reporting by Valentina Za in Milan, Paul Day in Madrid, Michele Kambas in Nicosia, William James and Emilie Matarise-Sithole in London; Writing by Paul Taylor; Editing by Mike Peacock and Alastair Macdonald)