Shares Drop as Bond Yields Oush Italy to the Brink

Asian stocks fell around 3 percent on Thursday after soaring Italian borrowing costs stoked fears that the debt crisis in the euro zone's third biggest economy will overwhelm its financial defenses, raising the risk of a breakup of the currency area.

The euro was steady, after suffering its biggest daily drop in 15 months on Wednesday, while industrial commodities such as copper and oil softened on worries of renewed recession. European shares were set to extend the previous day's losses.

Asian credit spreads blew out as the deepening crisis in Europe sapped investor appetite for risk, while safe haven assets such as Japanese government bonds were in demand.

Whatever they come up with, it doesn't avoid a European recession, said Su-Lin Ong, senior economist at RBC Capital Markets in Sydney.

The question now is just how deep it will be and whether this is going to bleed over into the banking system, because that is much more significant.

FINANCE SECTOR HAMMERED

Tokyo's Nikkei share average fell 2.9 percent, while MSCI's broadest index of Asia Pacific shares outside Japan lost 3.5 percent, with the financial and industrial sectors hammered hardest.

Hong Kong's Hang Seng Index, the Asian market that has tended to be most susceptible to European developments in recent months, was the biggest regional loser, falling 4.5 percent as banks such as HSBC led losses.

Financial spreadbetters expected Britain's FTSE 100 to open down 1.5 percent, while Germany's DAX and France's CAC-40 were called down 1.7 percent.

Italy has, for the time being, replaced Greece as the biggest source of concern in Europe's two-year-old debt crisis.

Italian 10-year bond yields rose above 7 percent on Wednesday, a level most market economists consider unsustainable for financing debt of more than 2 trillion euros.

A pledge by Italian Prime Minister Silvio Berlusconi to stand down failed to reassure bond markets that Rome has the will to bring its debts under control, and moves by two major clearing houses to raise the level of collateral needed for holders of Italian debt pushed the country near breaking point.

European and U.S. stocks fell steeply on Wednesday in response, with Wall Street shares losing more than 3 percent. S&P 500 futures traded in Asia were up slightly on Thursday.

TOO BIG TO BAIL

Ireland and Portugal were both forced to seek aid soon after their 10-year bond yields topped 7 percent, but a rescue for Italy would be on a different scale and Europe's bailout fund is widely considered inadequate for the task.

The European Central Bank (ECB), considered the only institution capable of repelling the bond market attacks, bought Italian bonds in substantial amounts on Wednesday, but is reluctant to go further to force down yields.

The markets were basically in a panic yesterday and the only thing that can give the euro at least a temporary respite is quick action from the ECB to lower Italian yields, said Koji Fukaya, chief currency strategist at Credit Suisse in Tokyo.

While many outside Europe are calling on the ECB to take a more active role, as other major central banks do, in acting as lender of last resort, Germany remains implacably opposed to what it views as a threat to the central bank's independence.

In a sign of the depth of fear gripping European capitals, EU sources told Reuters that French and German officials had held discussions about a euro zone split.

The single currency was steady around $1.3540, after tumbling around 2 percent on Wednesday.

The dollar was also steady against a basket of currencies, after surging in the previous session as investors scurried for safety, while yields on 10-year Japanese government bonds fell 1 basis point to 0.965 percent.

In Asian credit markets, spreads widened around 13 basis points on the Asia ex-Japan iTraxx investment grade index, a gauge of risk appetite.

Concerns about flagging demand knocked London Metal Exchange copper down 2.4 percent. U.S. crude oil edged down to $95.70 a barrel, while Brent crude dipped a touch to around $112.26.

We've moved from a low-growth scenario to one where there is a real threat of recession in the euro zone, and that's weighing on oil markets, said Ric Spooner, chief market analyst at CMC Markets in Sydney.

(Additional reporting by Miranda Maxwell in Melbourne and Antoni Slodkowski in Tokyo; Editing by Richard Borsuk)