* 5-Star/League document rattle markets
* But League dismisses debt forgiveness talk
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr
By Dhara Ranasinghe and Danilo Masoni
LONDON/MILAN, May 16 (Reuters) - Italy’s borrowing costs rose sharply on Wednesday and its stocks fell after a draft programme for the country’s potential coalition government revealed plans to demand 250 billion euros of debt forgiveness.
The anti-establishment 5-Star Movement and the far-right League party plan to ask the European Central Bank to forgive the debt, according to a draft the parties are working on, the Huffington Post Italia website reported late Tuesday.
The report spooked markets even though the League’s economic spokesman told Reuters that debt cancellation was never in an official draft of a government programme. Italian bonds and equities both stood out as euro zone laggards on Wednesday.
“The market is reacting negatively to this as this is a wake-up call for BTP (Italian bond) investors,” said Ioannis Sokos, a European rates strategist at Nomura in London.
“To be sure, this is very early days and most people believe a watered-down version will materialize finally, which also would be some concern to investors.”
The news pushed Italy’s debt insurance costs in the five-year credit default swaps market to 102 basis points, the highest since end-March, according to IHS Markit.
Italian 10-year bond yields rose past 2 percent for the first time in two months while the Italian/German spread, a closely-watched indicator of relative risk, jumped to 139 basis points.
The spread narrowed back to 137 bps after the League’s comments on debt forgiveness. Still, that kept it above levels traded late on Tuesday at 129 bps, reflecting some nervousness among investors.
“Italy does not have the bargaining power with Europe to ask that. The proposal is unfeasible and bound to fail. This explains why the market’s reaction is negative - but not as negative as it would have been if investors had believed there were chances for the proposal to succeed,” said Giuseppe Sersale, fund manger at Milan-based Anthilia Capital Partners.
Italian two-year bond yields rose to 0.007 percent to briefly trade above zero percent for the first time since May 2017, according to Reuters data.
Italian stocks were down 0.5 percent against a rise in the pan-European index.
Shares in Italian banks, considered a proxy for political risk in the country due to their large holdings of government bonds, were broadly lower, with a sectoral index down as much as 1.1 percent.
The euro held its ground, however, and was up 0.1 percent at $1.1853 after brushing $1.1815, its weakest since late December.
The 39-page document leaked on Tuesday also called for a renegotiation of Italy’s European Union budget contributions, an end to sanctions against Russia and plans to dismantle a 2011 pension reform that raised the retirement age.
It also proposed the creation in the EU of “economic and judicial procedures that allow member states to leave monetary union”.
The draft accord is likely to cause concern in Brussels and at ECB headquarters in Frankfurt and might also dismay Italian President Sergio Mattarella, who has repeatedly stressed the importance of the country maintaining a strong, pro-European stance.
Analysts said Mattarella’s influence was likely to help, while final proposals were unlikely to be as alarming as first feared.
“I think people will be willing to sit it out for now,” said Lyn Graham-Taylor, a fixed income strategist at Rabobank in London.
Italian markets have proved resilient to signs of a 5-Star/League government keen on big spending plans taking shape. The Italian/German bond yield gap remains below levels traded before the March 4 election. (Reporting by Dhara Ranasinghe, Tom Finn, Helen Reid and Saikat Chatterjee in London and Danilo Masoni in MILAN; Editing by Jon Boyle)