Italy Credit Downgraded, French Banks Pressured

Standard & Poor's cut Italy's credit rating on Tuesday in a surprise move that increased strains on the debt-stressed euro zone and raised pressure on policymakers to take more decisive action to resolve the crisis.

Analysts said the one-notch downgrade, citing poor growth prospects and political instability, was ominous for the global economy and would add to mounting strains on European banks.

S&P's rating is now three notches below rival agency Moody's, putting Italy below Slovakia and on a par with Malta.

In the latest signs of stress on the banking system due to the debt crisis, three sources said Bank of China had stopped foreign exchange forwards and swaps trading with the top three French banks and Switzerland's UBS.

A Paris-based source said German engineering giant Siemens withdrew an unknown amount in deposits from Societe Generale in July. SocGen came under fierce market pressure in early August. The bank declined comment.

Italy's downgrade overshadowed signs of progress in Greece's negotiations with international lenders to avoid running out of money within weeks, and news that Brazil was willing to pump in $10 billion through the IMF to aid Europe.

Italy is a much bigger deal than Greece, said Kathy Lien, director of currency research at GFT in New York.

Europe has come under increasing global pressure to resolve a crisis that has seen numerous sovereign rating downgrades and financial rescues for Greece, Portugal and Ireland. A bail out of Italy would overwhelm euro zone resources.

The Bank of China's decision to stop foreign exchange forwards and swaps trading with SocGen, BNP Paribas and Credit Agricole reflected a broad unease about counterparty risk in the euro zone crisis, three sources with direct knowledge of the matter said.

French banks are among the most heavily exposed to Greece, which many economists expect to default at some point. Shares in SocGen and BNP were both down more than three percent.

The head of the European Central Bank, Jean-Claude Trichet, urged in a newspaper interview that European banks strengthen their balance sheets to improve their resistance to the crisis.

Analysts said the crisis will have to be addressed by policymakers starting with the U.S. Federal Reserve Board meeting on Tuesday and Wednesday and the G20 and IMF/World Bank in Washington later in the week.

I think it's going to necessitate some sort of action by the G20 this weekend, said Lien.

The United States has heaped pressure on euro zone leaders to act more decisively but has received a decidedly cool response.

An EU document, obtained by Reuters, showed the bloc will call on China week to boost domestic demand and on the United States and Japan to tackle their public deficits as part of global efforts to rebalance growth, suggesting there will be no meeting of minds in Washington.

Italian Prime Minister Silvio Berlusconi said S&P's decision did not reflect reality and his government was already preparing measures to spur growth. Italian government bond yields rose on the news and the euro slid.

The assessments by Standard & Poor's seem dictated more by newspaper stories than by reality and appear to be negatively influenced by political considerations, Berlusconi said.

GREEK TALKS DRAG ON

A Greek finance ministry official said Athens was close to a deal with European and IMF inspectors on extra austerity measures to secure the release of an 8 billion euro loan installment vital to pay state salaries and pensions next month.

The international lenders are demanding public sector job cuts, higher heating oil tax and more pension cuts to close a gap in this year's budget deficit due to a deeper-than-forecast recession and poor revenue collection.

Finance Minister Evangelos Venizelos held what Greece termed productive and substantive talks by telephone with senior EU and IMF officials on Monday after promising as much austerity as necessary to win a vital next installment of aid.

Experts were thrashing out details all day on Tuesday and Venizelos will confer again with the EU/IMF mission chiefs by telephone at 1700 GMT, his office said.

Italy, the euro zone's third-largest economy, has been dragged to the center of the debt crisis over the past three months as concern have grown about its ability to handle debt equal to 120 percent of GDP.

S&P cut its ratings on Italy to A/A-1 from A+/A-1+ and kept its outlook negative. The move was a surprise because the market had thought Moody's was more likely to downgrade Italy first. Moody's said last week it would take another month to decide on its action.

Under mounting pressure to cut its debt, the Berlusconi government pushed a 59.8 billion euro austerity plan through parliament last week, pledging a balanced budget by 2013.

But there has been little confidence that the much-revised package of tax hikes and spending cuts, agreed only after repeated chopping and changing, will do anything to address Italy's underlying problem of persistently stagnant growth.

We believe the reduced pace of Italy's economic activity to date will make the government's revised fiscal targets difficult to achieve, S&P said in a statement.

China meanwhile said it was disappointed the European Union had not granted it market economy status that could protect it from trade sanctions, but pulled back from linking the issue to support for debt-stricken Europe.

Brazil could make up to $10 billion of its own money available to help Europe through various channels, including the IMF, or by making bond purchases and has urged other large emerging market countries to provide similar support, an official told Reuters.

It has previously said it was in talks with the four other big emerging economies or so-called BRICS -- Russia, India, China and South Africa -- to make coordinated purchases of bonds of euro zone countries.

Brazil's contribution by itself would almost certainly be too small to make a major difference to Europe's debt and it will have a tough time convincing its risk-averse fellow BRICs to bankroll a European rescue no matter how the aid is structured.

(Reporting by Reuters bureaus; Writing by Raju Gopalakrishnan and Paul Taylor, editing by Mike Peacock)