By Francesco Guarascio

LUXEMBOURG (Reuters) - The head of the euro zone's rescue fund said on Tuesday that Italy's free-spending fiscal plans were a risk that was troubling domestic banks, but cautioned against panic because contagion to other countries had been "very limited".

Italy's draft 2019 budget targets a deficit of 2.4 percent of gross domestic product (GDP), which is far above commitments made by the previous government and risks increasing the country's huge public debt pile in breach of EU fiscal rules. "There is a risk with Italy. We are worried about Italy because the fiscal plans are not compatible with the EU fiscal framework," Klaus Regling told a news conference in Luxembourg.

His comments came hours before the EU Commission discusses the next steps to take on a procedure that could lead to an unprecedented rejection of the Italian budget plan and, in the longer-term, to fines.

Regling, who chairs the Luxembourg-based European Stability Mechanism (ESM) rescue fund, stressed Italy's debt problems were different from those of Greece, which needed three euro zone bailouts over the last decade.

"One should not really get into panic here," Regling said, listing the differences between Italy's current situation and Greece's long crisis.

He said Italy's fundamentals were much more solid as the country had only a limited nominal deficit and a current account surplus, adding that its debt had a relatively long average maturity which helped shield the country from market pressure.

BANK WOES

Regling warned, however, about the risks faced by the Italian banking sector due to higher yields on government debt, which reduce the value of lenders' large holdings of Italian bonds and could force recapitalisations.

Since budgetary plans were agreed by Italy's eurosceptic government this month, the nation's funding costs have spiked and the gap between Italian and German 10-year bond yield spreads briefly reached its widest level in 5-1/2 years.

"It's sad what is happening to the Italian banks now because they were on a good way," Regling said, citing the rapid reduction of bad loans in banks' balance sheets and banking reforms over the last two years as positive developments.

"There was quite a positive trend. Now they suffer from the deterioration in the sovereign debt and that spills over very automatically. So that makes their life complicated again," he said.

Asked whether Italy should consider asking for ESM financial support for its banks as Spain did in 2012, Regling said the current situation was different due to stricter rules on EU banking and state aid.

"I would not recommend at the moment to go the same way (as Spain did)," Regling said.

Although Italy's debt woes have already spilled into the domestic banking system, Regling said there has been so far "very limited contagion" to other euro zone countries.

He added that "one or two" Greek banks had suffered due to contagion from Italy, but said their problems were also caused by very high levels of bad debt. He did not name the lenders.

(Reporting by Francesco Guarascio; Editing by Philip Blenkinsop and Helen Popper)

(This story has not been edited by Business Standard staff and is auto-generated from a syndicated feed.)