By James Mackenzie and Deepa Babington
ROME (Reuters) - A quick agreement by Italy's government and opposition to pass a closely watched austerity package helped calm markets on Wednesday, but there were calls for further steps to reductions in the deficit.
Facing a market rout after stocks plunged and borrowing costs hit record highs on Tuesday, government and opposition parties shelved their differences and agreed to ensure quick approval of a four-year, 40 billion euro austerity plan.
"The market remains nervous, very attentive, but we had an Italian reaction that was remarkably fast on budget austerity," said Deutsche Bank analyst Gilles Moec.
"The growth issue remains, but there was an immediate, patriotic reaction by the Italian political class that has positively impressed investors."
Economy Minister Giulio Tremonti, widely seen as the guarantor of Italian financial stability, said the government's austerity package would be approved by Friday, and he brushed aside rumors that he may step down.
"Hic manebimus optime," he told a meeting of the Italian banking association, borrowing a phrase from the Roman historian Livy meaning: "We will stay here, extremely well."
At the same event, European Central Bank Governing Council member Mario Draghi urged the government to move ahead with further measures to ensure it meets its target of bringing the budget back into balance by 2014.
"The substance of future measures aimed at balancing the budget by 2014 should be defined as rapidly as possible," he said. "This is what markets are looking at above all today."
He also criticized the European policy response to the debt crisis, saying policymakers needed to "bring certainty to the process by which sovereign debt crises are managed" with clearly defined objectives and instruments.
International Monetary Fund economists have urged "decisive implementation" by Italy to cut its huge public debt, noting that the austerity plan was based on optimistic forecasts with measures weighted toward later years.
Market falls on Friday and Monday wiped around 26 billion euros off the FTSE MIB blue-chip index and sent Italian bond yields up to more than 6 percent, the highest since the launch of the euro more than a decade ago.
On Wednesday, the premium investors demand to hold Italian debt rather than safe-haven German bonds narrowed by 11 basis points to 280 basis points -- after hitting a euro lifetime high of 353 basis points at one stage on Tuesday.
The yield on the 10-year BTP bond stood at 5.46 percent, down 13 basis points but still 46 basis points higher than its levels a week ago.
With the BTP spread against German Bunds narrowing, Italian bank shares -- which have born the brunt of the sell-off because of their vast holdings of government paper -- recovered some of the heavy losses they had suffered on Friday and Monday.
However, Goldman Sachs cut its price targets on Italian banks by 12 percent on average due to expected higher funding costs and lower profitability after the recent rise in Italian government bonds.
MARKET TEST LOOMS
A further test of Italy's ability to keep tapping the markets comes on Thursday, when the Treasury offers up to 5 billion euros of long-term BTP bonds, and markets are waiting nervously to see how the auction succeeds.
If Italy, the third-largest economy in the euro zone, were to share the same fate as Greece or Ireland, consequences would be incalculable. Much too big to bail out, a severe crisis could call the future of the entire euro area into question.
Ratings agency Fitch said on Wednesday it expected the government to succeed in cutting the deficit and said the market turmoil did not reflect Italy's fundamentals.
"The sharp rise in Italian and other euro zone government bond yields in recent weeks reflect a crisis of market confidence in the European policy response to the euro zone debt crisis rather than deteriorating sovereign credit fundamentals," Fitch said in a statement.
Italy has a public debt equivalent to around 120 percent of gross domestic product, second only to Greece in the euro zone and compounded by one of the world's most anemic growth rates.
Tight spending controls, a conservative banking system and a high rate of private savings have helped shield it from the worst of the euro zone debt crisis, but the sell-off this week is a reminder of its potential vulnerability.
A senior Bank of Italy official said the impact of the recent surge in yields was limited in the short term but would be considerable if it persisted -- adding around 3 billion euros to government borrowing costs in the first year and more later.
"If these kind of levels persist, the burden for public finances would be severe," Ignazio Visco, deputy director general of the Italian central bank, told a Senate hearing.
(Additional reporting by Giuseppe Fonte, Michel Rose, Valentina Za, Nigel Tutt, Luca Trogni and Elvira Pollina in Milan; Writing by Silvia Aloisi and James Mackenzie; Editing by Hugh Lawson)