Gold medallist Luca Ferretti (2nd L) of Italy is flanked by his compatriots silver medallist Simone Ercoli (L) and bronze medallist Simone Ruffini as well as joint bronze medallist Spyridon Gianniotis (R) of Greece as the flag of Italy is raised during the medal ceremony of the men's 5 km open water race at the European Swimming Championships in Lake Balaton in Balatonfured August 5, 2010. REUTERS/Wolfgang Rattay (HUNGARY - Tags: SPORT SWIMMING)

Muted bond market reaction to Italy's decision on Wednesday to relax its budget deficit targets and promote economic growth shows investors still have confidence in Prime Minister's Mario Monti's management - at least for now.

For markets Italy is a known quantity. Monti is a familiar figure after serving as a European Commissioner for almost a decade until 2004 and the country's problems are also well known: it has struggled for many years with a huge state debt and a weak economy.

By contrast, Spain is less of an known quantity for markets, which took it badly when Madrid also relaxed its budget targets.

Prime Minister Mariano Rajoy is a less familiar figure outside his home country than Monti, and doubts persist over whether his four-month-old government can tackle a property crash, a banking system that may need rescuing and Spain's free-spending regional governments.

“Clearly the technocratic government in Italy carries a lot more respect in international markets,” Investec chief economist Philip Shaw said. “Any policy judgement is likely to be regarded more favourably with Monti's government.”

On Wednesday, Monti's government raised its budget deficit target for 2013 and said it would balance its books only in 2014, a year later than promised. It also forecast a deeper recession this year. Nevertheless, Italian 10-year government bond yields were only 3 basis points higher on the day at 5.51 percent.

By contrast, when former Italian premier Silvio Berlusconi also wanted to balance the budget in 2014 rather than 2013 - just as Monti is doing now - Italian yields jumped into danger territory above 7 percent, levels seen as unaffordable.

Spain suffered similar treatment from the markets in early March when it set itself a softer budget target for 2012: borrowing costs began to accelerate and it became the focus of a new flare-up of the euro zone debt crisis.

BETTER THAN SPAIN, FOR NOW

As long as Monti's reform drive remains credible, Italian government bonds are expected to outperform their Spanish counterparts, some analysts say.

Concerns about Spain's public finances, its falling housing market and risks that the government may need extra funds, possibly from the EU, to recapitalise banks pushed 10-year Spanish bond yields above 6 percent this week.

That level is important for markets as the rise in yields has accelerated on previous occasions when it was broken. A further increase would deepen concerns that Spain may need outside help and widen the yield premium over Italian bonds.

Markets are willing to give Monti the benefit of the doubt provided he doesn't let things slip any further.

Rabobank strategist Richard McGuire laid out the fundamental differences between the two struggling southern European economies: “Italy's known known, which is the very large debt stock, versus Spain's known unknowns, which are the ability to control its regions, the weakness of its housing market and the possibility of banking bailouts.”

This means that markets are betting that Italian bonds will outperform Spain's. However, McGuire added: “Any further slippage from Italy may challenge that view.”

A further reason for the moderate market reaction to Monti was the scale of the revisions. Italy only raised its 2012 deficit goal to 1.7 percent of economic output from 1.6 percent.

On the other hand, Rajoy's government revised the budget deficit to 5.3 percent of GDP from 4.4 percent, moving even further away from the European Union's 3 percent ceiling.

Financial markets had already expected a wider Italian deficit, bond strategists said, and investors are more worried about whether Rome is sticking to growth-boosting reforms.

Monti addressed this issue. “Everything, everything, everything that we are doing now is aimed towards helping growth,” he said after his cabinet approved the new targets.

Markets believe that the effectiveness of labour market legislation, the centrepiece of Monti's reform plans, is vital for Italy's credibility. The laws are susceptible to major alterations in parliament.

“(The forecast revision) is not a fundamental change, the numbers we are looking at are a modest change,” RBS euro area economist Silvio Peruzzo said. “The labour law is what the market is looking at to gauge the (resilience) of Monti's government and its ability to reform. It is a symbolic and emotional element for markets.”

Italy has been an economic laggard within the euro zone over the past decade, and its debts are among he highest in the world at 1.2 times the size of its annual economic output, but it has maintained relatively low budget deficits.

This year, the economy is forecast to contract 1.2 percent, compared with the previous estimate of 0.4 percent.

“The Italians have always been virtuous with their budget deficit,” ING rate strategist Alessandro Giansanti said. “What the market is looking at in Italy is growth, not the deficit. But many economists already expect a contraction in the 2 percent area so the market can digest the news easily.” - Reuters