He commented: “A ‘bad peace’ is always better than a ‘good war’”

By Peter Apps, Political Risk Correspondent

  LONDON (Reuters) - As tension rises over Iran's disputed nuclear program, chatter indicating a potential Israeli strike on Iranian nuclear targets has never been higher.

  But in the smoke-and-mirrors world of Middle East geopolitics, such talk can often be a diplomatic weapon in its own right and sometimes an alternative to genuine action.

  To an extent, the recent storm of speculation and newspaper stories are just an escalation in a long-running game of words. Tehran says its program is purely peaceful, not designed to yield nuclear weapons, but U.S., Israeli and other Western officials have often warned that, if it continues unabated, Israel might take unilateral action and bomb key facilities.

  But the United States and Israel in particular have never gone to such lengths to suggest that a strike might be imminent.

  Discussion of potential military and other options - and an increasingly public discussion between the United States and Israel over what to do next - will move further into plain sight Monday with Israeli Prime Minister Benjamin Netanyahu's visit to Washington to meet President Barack Obama.

  While U.S. officials say they want to dissuade Israel from striking, Obama's Republican opponents are eager to paint him as too tough on Israel and too soft on Iran ahead of November's presidential election. Netanyahu wants more U.S. support, including endorsement of any action Israel might take.

  " The drumbeat for military action is getting louder," says Michael Denison, research director for London-based consultancy Control Risks and a former senior adviser in Britain's Foreign Office. " But that doesn't necessarily mean it will happen soon."

  U.S. officials have repeatedly briefed journalists - including those from Reuters - to say that they no longer know what those in charge in Israel might be planning, and that Washington does not expect advance warning of an attack.

  European officials say they too are pushing hard to restrain Israel from action that might spark a wider regional conflict, but increasingly fear they will be unable to do so.

  Israeli officials have been more reticent, and many recent stories in the Israeli press may in part be lifted from European and U.S. media. But recently, Israeli officials too have held background briefings in London with businesses and think tanks.

  Some have gone beyond the usual threatening statements, usually on no options being ruled out, that have come to be expected from Netanyahu and Defense Minister Ehud Barak.

  The precise message has varied, particularly over the time it might take Tehran to genuinely be able to build a nuclear bomb. But the thrust is clear: As Iran's nuclear enrichment and wider development moves forward and its facilities are dug ever deeper into the ground, time is running out.

  Israel, widely believed to harbour the Middle East's only nuclear arsenal, sees Iran's atomic campaign as a mortal threat.

  A USEFUL BLUFF?

  Trailing an attack in advance might have certain advantages, analysts say. Financial markets would be largely prepared, reducing the economic shock.

  Benchmark Brent crude oil prices have gained some $15 a barrel over the last month to around $125. Almost all of that, oil experts say, has been down to escalating tensions with Tehran: partly speculation of an Israeli strike, partly the loss of Iranian crude supply due to tightening Western sanctions.

  But the real agenda, some suspect, is much more about shaping the diplomatic battlefield.

  " Barak and Netanyahu think that this (talk of an Israeli attack) is the only tool that gets the players moving," Udi Segal, diplomatic correspondent for Israel's top rated Channel Two television news, said in a commentary last week.

  " And even if this is a bluff, it is a bluff that should not be allowed to be ruptured because it makes the Iranians feel fear, the Americans take action, the Europeans impose sanctions, and everyone worry."

  If Netanyahu and those around him had genuinely decided to strike, many experts say they would simply do so rather than pre-briefing the media.

  Few doubt Israel does have the ability to strike targets deep inside Iran, using either jets, long-range drones or submarine- or land-launched launched missiles.

  But in reality, it finds itself hugely constrained.

  A strike could provoke a massive backlash, both diplomatic and through Iranian-backed groups such as Hezbollah in Lebanon and Hamas in the Gaza Strip. Tehran might make good threats to hit international oil tankers in the Strait of Hormuz.

  Even were such a conflict relatively brief, it could send oil prices rocketing and jeopardise a fragile global economy.

  " NO GOOD OPTIONS"

  And few experts believe an Israeli strike would put the Iranian weapons program back more than a few months or years.

  Worries about the broader impact - particularly from Washington - are seen as having deterred Israel from a strike in 2008-9, another period of heightened speculation. Instead, Israel, perhaps working with the United States, is believed to have gone for a more covert approach including the computer worm Stuxnet, which affected Iranian nuclear technology.

  But such attacks are only ever partially effective, experts say, and assassinations of nuclear scientists widely blamed on Israel - which has made no comment on the matter - have also proved increasingly controversial.

  " The Israelis do not have any good options and so they are simply sending every signal under the sun," Anthony Cordesman, a veteran former U.S. intelligence official and now chair of strategy at the Washington-based Center for Strategic and International Studies, told Reuters last month.

  Some experts question to what extent an Iranian bomb would truly be a strategic game changer.

  Tehran is already believed to have ballistic missiles with chemical warheads able to strike Tel Aviv. Even if Iran successfully assembled the four bombs that Israel says it has the uranium to build, Israel would still have many more, and the ability to inflict much more catastrophic damage.

  Intelligence experts and officials, some of them Israeli, say it is still far from clear that Tehran has made a final decision to build a nuclear warhead.

  But the further the nuclear program moves forward, the quicker Iran could have one should it make that final decision. For a country that has had to fight several times for its survival in the 65 years since it was founded by the survivors of a genocide, the risks may simply be too high.

  " The important thing is that the Israelis believe it would be an existential threat," said one Western official heavily involved with the Iran issue. " That is the point. That's really what it has always been about."

  (Additional reporting by Dan Williams in Jerusalem and Mark Hosenball in London Editing by Kevin Liffey and Mark Heinrich)

By Parisa Hafezi and Zahra Hosseinian

  TEHRAN (Reuters) - Iranians voted on Friday in a parliamentary election likely to reinforce Supreme Leader Ayatollah Ali Khamenei's power over rival hardliners led by President Mahmoud Ahmadinejad.

  Iranian leaders were looking for a high turnout to ease an acute crisis of legitimacy caused by Ahmadinejad's re-election in 2009 when widespread accusations of fraud plunged the Islamic Republic into the worst unrest of its 33-year history.

  Iran also faces economic turmoil compounded by Western sanctions over a nuclear programme that has prompted threats of military action by Israel, whose leader meets U.S. President Barack Obama in the White House on Monday.

  The vote in Iran is only a limited test of political opinion since leading reformist groups stayed out what became a contest between the Khamenei and Ahmadinejad camps.

  " Whenever there has been more enmity towards Iran, the importance of the elections has been greater," Khamenei, 72, said after casting his vote before television cameras.

  " The arrogant powers are bullying us to maintain their prestige. A high turnout will be better for our nation ... and for preserving security."

  The vote will have scant impact on Iran's foreign or nuclear policies, in which Khamenei already has the final say, but could strengthen the Supreme Leader's hand before the presidential vote next year. Ahmadinejad, 56, cannot run for a third term.

  Iranians may be preoccupied with sharply rising prices and jobs, but it is Iran's supposed nuclear ambitions that worry the outside world. Western sanctions over the nuclear programme have hit imports, driving prices up and squeezing ordinary Iranians.

  OBAMA-NETANYAHU TALKS

  Just days away from the talks between Obama and Israeli Prime Minister Benjamin Netanyahu, their aides were scrambling to bridge differences over what Washington fears could be a premature Israeli attack on Iran's nuclear sites.

  Netanyahu will press Obama, who is facing a presidential election campaign, to stress publicly the nuclear " red lines" that Iran must not cross, Israeli officials say.

  Global oil prices have spiked to 10-month highs on tensions between the West and Iran, OPEC's second biggest crude producer.

  The election took place without two main opposition leaders. Mirhossein Mousavi and Mehdi Karoubi, who both ran for president in 2009, have been under house arrest for more than a year.

  No independent observers are on hand to monitor the voting or check the turnout figures that officials will announce.

  Former president Hashemi Rafsanjani made a pointed reference to the outcome of the 2009 vote, which he questioned at the time. " If the election outcome turns out to be what the people cast in the ballot boxes, God willing we will have a good parliament," the elder statesman said after voting in Tehran.

  Ahmadinejad also voted, but state media did not immediately show this or report any comment he might have made. The outgoing parliament is due to grill him next week on his handling of the economy and other issues - an unprecedented humiliation for an incumbent president, but one he may use to hit back at his foes.

  Polling stations opened at 8 a.m. (4:30 a.m. British time) and were due to close at 6 p.m., but might stay open longer. Ballots are counted manually and Iran may have to wait three days for full results.

  Voting was slow at first in affluent northern Tehran but picked up later. Voters queued up in poorer parts of the capital and in provincial cities, Reuters witnesses said.

  " I am here to support my establishment against the enemies' plot by voting," said Mahboubeh Esmaili, 28, holding her baby in a queue of about 50 people at a central Tehran polling centre.

  SLAP IN FACE

  Khamenei has told Iranians that their vote would be a " slap in the face for arrogant powers" such as the United States.

  A U.S. official said Iran had clamped down on dissent since the turbulent presidential election nearly three years ago.

  " Since then, the regime's repression and persecution of all who stand up for their universal human rights has only intensified," U.S. Under Secretary of State Mario Otero told the United Nations Human Rights Council in Geneva.

  U.N. human rights chief Navi Pillay said in her report to the council she was alarmed at a " surge in executions" reported in Iran in the past year. She gave no figures.

  The two main groups competing for parliament's 290 seats are the United Front of Principlists, which includes Khamenei loyalists, and the Resistance Front that backs Ahmadinejad.

  The president, a blacksmith's son, has long appealed to Iran's rural poor with his humble image and cash handouts from state funds, but spiralling prices have dented his popularity.

  Energy and food imports have been hit by sanctions aimed at forcing Iran to halt sensitive nuclear work that the West suspects is a cover for a drive to build atomic bombs. Tehran says it has only peaceful aims, such as generating electricity.

  Prices of staple goods, many of them imported, have soared because the Iranian rial's value has sunk as U.S. and European Union sanctions on the financial and oil sectors begin to bite.

  Ahmadinejad's critics accuse him of making things worse for low-income Iranians, saying his decision to replace food and fuel subsidies with direct monthly payments since 2010 has fuelled inflation, officially running at around 21 percent.

  ALLIES FALL OUT

  The president enjoyed solid support from Khamenei in the months of " Green Movement" protests that followed the 2009 election, but the two men have fallen out badly since then.

  For Khamenei, the parliamentary election could reinforce his grip on power against a president seen as trying to undermine the clergy's central role in Iran's complex political hierarchy.

  Ahmadinejad and his " deviant current" allies have alarmed Khamenei's conservative camp by emphasising nationalist themes of Iranian history and culture over the Islamic ruling system introduced by revolutionary leader Ayatollah Ruhollah Khomeini.

  Khamenei succeeded Khomeini, who died in 1989.

  Some Iranian media reports said Ahmadinejad hoped to secure the election of his chief of staff, Esfandiar Rahim-Mashaie, to succeed him. Khamenei will want to install one of his own loyalists to prevent further divisions within the ruling elite.

  Powerful establishment groups, including senior clerics, the elite Revolutionary Guards and bazaar merchants, formed an alliance to back Khamenei loyalists in the parliamentary vote.

  Not everyone can run in Iranian elections. The hardline Guardian Council, made up of six clerics and six jurists who vet candidates, approved more than 3,400 out of 5,382 applicants.

  Some politicians said the council barred many established Ahmadinejad supporters, forcing him to pick political unknowns.

  The rift between Khamenei and Ahmadinejad broke into the open in April 2011 when the Supreme Leader forced the president to reinstate an intelligence minister he had insisted on firing.

  Khamenei has kept up the pressure in recent months. Dozens of Ahmadinejad allies have been detained or sacked for links to the " deviant current."

  Most strikingly, the president's media adviser, Ali Akbar Javanfekr, has received a one-year jail term for insulting Khamenei, which an appeal court upheld on Wednesday.

  The authorities suggested that malign foreign hands were trying to disrupt the election.

  " So far, 10 saboteurs who came to Tehran from outside the country have been arrested and are now in detention," Mohammad Taqi Baqeri, a Tehran election official was quoted as saying by the semi-official Fars news agency. He gave no details.

  (Additional reporting by Hashem Kalantari in Tehran, Marcus George in Dubai and Matt Spetalnick in Washington Writing by Alistair Lyon Editing by Mark Heinrich)

By Hanna Rantala

  GROSSETO, Italy (Reuters) - The captain of a giant cruise liner which capsized off Italy, killing at least 25 people, could be in danger if he attends a pre-trial hearing on Saturday into the disaster, his lawyer said.

  Prosecutors have accused captain Francesco Schettino of causing the accident by bringing the multi-storey Costa Concordia too close to the shore of the Mediterranean island of Giglio in January, where it was torn open by rocks.

  He has already been held up to condemnation and ridicule around the world.

  Seven people are unaccounted for and divers are still looking for bodies in the capsized and partly submerged vessel.

  A hearing will be held in a theatre in the Tuscan town of Grosseto on Saturday, when judges will question experts about the wrecking of the 114,500 tonne liner.

  Lawyer Bruno Leporatti told Reuters Television in Grosseto that the captain " is a man who has feelings, who is pained over what happened. He feels pain for the victims, naturally and is stunned by all that is going on."

  Schettino, who spent three decades at sea, is under house arrest in his home in Meta di Sorrento, near Naples.

  " Captain Schettino will not attend the pre-trial hearing because it is not of use or any help if he embarks on a return trip of 850 km from where he is held under house arrest, just to be present, which would be unnecessary and perhaps with this climate that has been created around him, also a little dangerous for him," Leporatti said in the interview this week.

  Schettino is accused of a string of charges including multiple manslaughter and abandoning ship before the evacuation of more than 4,200 passengers and crew.

  First officer Ciro Ambrosio and seven other ships' officers and executives of the ship's owners, Costa Cruises, are also under investigation.

  SECOND COSTA LINER IN TROUBLE

  The hearing will come after 627 passengers disembarked in the Seychelles on Thursday from another Costa liner, the much smaller Costa Allegra, which had to be towed for three days by a French fishing boat in the Indian Ocean after a fire knocked out its engines.

  Leporatti said the Grosseto hearing starting on Saturday, whose duration is unclear, would confirm what Schettino had said about the disaster from the start.

  " The new results from the investigations, the new visual evidence, show a completely different reality from what was originally claimed ... immediately after the incident."

  " We have seen a completely different take on things from what everyone has been trying to make us believe," he said.

  Leporatti said Schettino, who is blamed for bringing the Costa Concordia to within a stone's throw of shore in a display manoeuvre known as a " salute" to islanders, had always said he should not be the only one blamed for the tragedy.

  He said investigations were showing that " there are also others, whose actions are currently being evaluated by the investigators and hopefully there will be even more."

  Among those under investigation are the vice president of Costa, Manfred Ursprunger, and the head of its crisis unit, Roberto Ferrarini, with whom Schettino was in contact during the evacuation.

  The company, a unit of the world's largest cruise operator, Carnival Corp, has blamed Schettino for the accident.

  Many townspeople in Meta di Sorrento have been supportive of Schettino since his arrest, in contrast to media treatment elsewhere in Italy and abroad.

  " Let's wait to hear what the trial will say before we condemn him. This man has been executed before the trial has even started and you (the press) have executed him," said resident Rosa Tito on Friday.

  Another man in Meta, who asked not to be named, told Reuters: " I know from people who have known him and who have sailed with him that he has always been an excellent officer ... I don't know why he made the choices he did. I really don't know what may have gone through his head."

  Hundreds of Italian and foreign journalists, together with television satellite trucks, are gathering in Grosseto, which is the centre of the investigation into the shipwreck.

  Judges will be ordering tests on the black box recorders from the ship when the hearing opens on Saturday. Local media said around 70 lawyers and their teams, representing survivors and relatives of victims, among others, were expected to attend Saturday's hearing.

  The theatre where it is being held can hold more than 1,000 people but the hearings will not be open to the public or journalists.

  (Additional reporting by Eleanor Biles Writing by Barry Moody Editing by Alison Williams)

* Prices off 11-month high as Saudi supply fears wane

  * Saudi denies incident but market remains jittery

  * IMF says probability of sharp economic slowdown has eased

  * Enough spare capacity to make up for Iran -U.S. energy sec (Adds quotes para 10, 13, updates prices)

  By Zaida Espana

  LONDON, March 2 (Reuters) - Crude oil futures slipped below $125 a barrel on Friday, after surging 5 percent to an 11-month high a day earlier, as fears of a supply disruption from Saudi Arabia eased, calming investors who now expect oil demand to fall in coming weeks.

  Oil prices soared on Thursday after an Iranian media report of a pipeline fire in top exporter Saudi Arabia, although prices later dipped back after CNBC cited a Saudi oil official saying the report was untrue.

  By 1321 GMT, front-month Brent crude was down by $1.31 to $124.89 a barrel, after settling the previous session at highs not seen since April 2011 of $126.20.

  Brent topped $128 a barrel in late post-settlement trade on Thursday, reaching levels last seen in July 2008, when oil hit a record of more than $147 a barrel.

  " Most people believe the retracements to the downside are all going to be pretty limited in the short term," said Tony Machacek, an energy broker at Bache Commodities.

  Top oil exporter Saudi Arabia said on Friday there had been no attack in the kingdom, but traders are jittery about any potential disruptions to its production or infrastructure at a time of setbacks to global supplies.

  " The general belief is that the market is going to remain relatively tight and relatively well supported: the underlying long term fundamentals remain good on demand from China and India. Throw into the mix a bit of geopolitical tension, and obviously Iran, and that's enough to keep people not wanting to go short into the weekend," Machacek said.

  U.S. crude oil futures were down 77 cents to $108.07 a barrel, after settling $1.77 higher at $108.84.

  Markets have been on edge this year due to threats of supply disruptions from the West's standoff with Iran over its nuclear program and production losses from South Sudan, Yemen, Syria and the North Sea.

  " Even after the return of a tranche of Libyan output, the system is still highly exposed to relatively minor variations in output elsewhere," Barclays Capital analysts said in a note.

  " Combine that lack of inventory cover with an upstream system that is running rather hot at more than 98 percent of sustainable capacity, and the result is that supply-side fluctuations are felt faster and have larger impacts on physical differentials."

  Commerzbank's analyst Carsten Fritsch noted that despite Saudi's denial, a large portion of yesterday's price increase is still intact.

  " Even if the original story came from Iran and no doubt was spread deliberately, the market clearly believes there to be an increased risk of supply shortfalls. This price reaction reveals how selectively market players are willing to take information on board - a typical feature of phases of exaggerated speculation," Fritsch said.

 

 

  IRAN STRUGGLING TO SELL CRUDE

  Iran, OPEC's second biggest producer, has been struggling to sell its crude in the face of tightening U.S. sanctions and a European Union embargo that kicks in on July 1. This has threatened to tighten global crude supplies.

  However, U.S. Energy Secretary Steven Chu said global oil producers have enough spare production capacity to make up for a drop in Iranian exports.

  Oil prices have also been underpinned this week by positive manufacturing data out of China, easing fears of a sharp drop in demand from the world's second biggest oil consumer, and by a flood of cheap funds from the European Central Bank.

  The probability of a sharp global slowdown has eased due to recent policy measures adopted in the euro zone to tackle its debt crisis, the International Monetary Fund said on Thursday, but it warned risks to world growth remain " squarely to the downside" . (Reporting by Zaida Espana in London and Francis Kan in Singapore editing by Anthony Barker and Keiron Henderson)

* FTSEurofirst 300 index drops 0.2 percent

  * Spain's budget target weighs on sentiment

  * Bank shares remain cheap despite rally (Updates)

  By Harro Ten Wolde

  FRANKFURT, March 2 (Reuters) - European shares retreated on Friday afternoon after Spain signalled a higher deficit this year than previously agreed with the European Union, ending a rally that followed the ECB's funding exercise this week.

  The FTSEurofirst 300 index of top European shares was down 0.2 percent at 1,084.38 points at 1305 GMT, retreating from 1,090.12, its highest level since Feb. 21.

  Prices fell after Prime Minister Mariano Rajoy said Spain will base its 2012 budget on a deficit target of 5.8 percent of gross domestic product.

  " This is clearly less ambitious than the market was expecting," a German trader said, adding that the official EU-agreed objective was 4.4 percent.

  " It seems investors are just waiting for excuses for a correction," another German trader said.

  Rajoy made his remarks on the sidelines of the two-day European summit that ends on Friday, where leaders have been arguing over the right balance between budget austerity and recapturing lost growth.

  Finance ministers gave provisional approval to a second bailout for Greece, while leaders of 25 of the 27 countries are expected to sign a German-driven fiscal compact treaty to enforce EU deficit-cutting and debt reduction rules more strictly.

 

  BANKS STILL CHEAP

  Banking shares shed most of its early gains, leaving the STOXX Europe 600 Banking index up just 0.4 percent. The index has gained about 25 percent since mid-December when the ECB launched its first long-term refinancing operation (LTRO).

  Analysts said that with so much liquidity in the financial system, the fear of an outright credit crunch had eased and expectations had grown grew that a recession in some European countries would be limited in depths and duration.

  Still, banking shares remain cheap despite their recovery.

  Since the ECB's first LTRO, Societe Generale has risen 50 percent, BNP Paribas has gained 27 percent, Commerzbank has added 50 percent and KBC is up 78 percent.

  However, SocGen trades at 6.6 times 2012 expected earnings, Commerzbank at 7.2 times, BNP Paribas at 6.8 times, KBC at 4.8 times, well below a 10-year average price-to-earnings ratio of 10 for the sector, according to Thomson Reuters Datastream.

  Barclays was up 3.1 percent after it said it tapped the ECB for 8.2 billion euros.

  ING shares added 2.3 percent after a court victory which means it may sell fewer assets than expected.

  Belgacom, down 4.2 percent, was the steepest faller on the STOXX 600 Index after Belgium's dominant telecom operator said its profit decline would accelerate in 2012. ($1=0.7501 euros) (Additional reporting by Blaise Robinson in Paris Editing by David Cowell)

(Corrects first paragraph to clarify nine weeks of gains on S& P futures, not major indexes)

  * S& P futures on track to close on 9th week of gains

  * Consumer website Yelp IPO prices at $15 a share

  * Futures off: Dow 35 pts, S& P 6 pts, Nasdaq 8.25 pts

  By Rodrigo Campos

  NEW YORK, March 2 (Reuters) - Futures on the S& P 500 edged lower in sparse volume on Friday in a light day on the economic calendar but were still on track to close their ninth straight week of gains, the longest such run since January 2004.

  Futures have traded in a tight range in the past two weeks, mostly holding on to gains of nearly 10 percent since the beginning of the year.

  " This has been a straight up move in prices, and it is unusual for that to continue," said Rick Meckler, president of investment firm LibertyView Capital Management in New York.

  " In order to avoid (a pullback) we need a continued flow of good news, and there aren't many earnings forecasts coming in right now, which could be the next push," Meckler said. " People will focus on possible negatives and right now the biggest out there is oil prices."

  U.S. crude oil futures hovered near $108 a barrel a day after hitting a 10-month high above $110 on supply concerns in the Middle East.

  Aides to U.S. President Barack Obama and Israeli Prime Minister Benjamin Netanyahu are scrambling to bridge differences over what Washington fears could be an Israeli attack on Iran's nuclear sites, a concern at the heart of the recent spike in oil prices. Both leaders will meet on Monday.

  New York's Institute for Supply Management February index of regional business activity is due at 9:45 a.m. (1445 GMT).

  S& P 500 futures fell 6 points and were below fair value, a formula that evaluates pricing by taking into account interest rates, dividends and time to expiration on the contract. Dow Jones industrial average futures dipped 35 points and Nasdaq 100 futures lost 8.25 points.

  Yelp Inc's initial public offering of class A common stock priced at $15 a share, above the expected price range, valuing the U.S. consumer review website at nearly $900 million.

  Close-out retailer Big Lots Inc posted a higher quarterly profit, helped by strong demand for its discounted products. (Reporting by Rodrigo Campos Editing by Padraic Cassidy)

* FTSEurofirst 300 up 0.2 pct early, Nikkei ends up 0.7 pct

  * Yen slips to nine-month low versus dollar

  * Brent crude futures falls below $126

  * Bund futures inch higher

  By Blaise Robinson

  PARIS, March 2 (Reuters) - European and Asian stocks climbed on Friday as appetite for risky assets continued to improve following the European Central Bank's huge cash injection, while the yen hit a nine-month low versus the dollar and Japanese importers sold yen.

  The FTSEurofirst 300 index of top European shares was up 0.2 percent in early trade, led by a rally in banking shares such as Commerzbank and Societe Generale .

  " The ECB's action does appear to have made a significant difference and people are more relaxed now. The fact that Italian bond yields have been on a decline in recent days is certainly a helpful factor," said Keith Bowman, equity analyst at Hargreaves Lansdown.

  The ECB's half a trillion euros in cheap, 3-year loans added to the banking system this week has helped fuel a 2-1/2 month recovery rally in risky assets, driving down bond yields of debt-stricken euro zone governments such as Italy.

  However, the rally that had been sparked by the ECB's first long-term funding operation in mid-December was showing signs of exhaustion on Friday, with European stock indexes failing to convincingly break above key resistance levels while the euro fell below $1.33.

  German Bund futures rose, with higher-yielding euro zone government debt looking vulnerable to profit-taking after the ECB's latest cash injection drove Italian two-year yields to their lowest levels in 15 months.

  " Periphery has had a very good run. I just wonder if it's done a little bit too much too quickly. Italy has tightened this much at the front end, we might see a bit of profit taking and core markets stabilising as well," a trader said.

  The dollar rose to a nine-month high against the yen on Friday on reported yen-selling by Japanese importers, the dollar rose 0.7 percent on the day to 81.718 yen on trading platform EBS, its highest level since late May.

  The Japanese currency has taken a hit after the Bank of Japan's surprise monetary easing in February, while the dollar found some reprieve this week after U.S. Federal Reserve Chairman Ben Bernanke stopped short of signalling more stimulus.

  Japan's Nikkei average reached a seven-month closing high on Friday, but it failed to hold above 9,800 for a third day as market players warned of a potential correction in the cards.

  Brent crude futures slipped below $126 a barrel after surging 5 percent to an 11-month high a day earlier, as concerns over a supply disruption from Saudi Arabia eased.

  " Oil prices have overshot in the short-term, and with warmer temperatures as we move from winter to spring, oil demand could start to fall, starting in March," said Gordon Kwan, head of energy research at Mirae Asset Management in Hong Kong. " Brent could fall back below $120 if Iran doesn't flare up." (Additional reporting by Atul Prakash and Emelia Sithole-Matarise in London)

* S& P cut Italy rating to +BBB in January

  * Italian yields back away from record highs

  * Says focus on growth, debt (Adds quotes, details, background)

  MILAN, March 2 (Reuters) - Italy must lay the foundations for economic growth and get its debt under control to return to a sovereign 'A' rating, a Standard & Poor's official told newspaper Il Sole 24 Ore for its Friday edition.

  Market confidence in Italy has improved after Italian banks, awash with cheap ECB funds, bought domestic bonds at recent sales, but Rome still has to roll over a mountain of debt in the first quarter alone.

  In January S& P downgraded Italy's sovereign debt by two notches to 'BBB+' with a negative outlook, citing concerns over the euro zone debt crisis.

  " The first step for Italy will be to take the outlook from negative to positive. And this will depend on the trend of debt, growth and the impact of the reforms implemented by the Monti government," Myriam Fernandez de Heredia, S& P's managing director for sovereign ratings in Europe, the Middle East and Asia, told the newspaper.

  " Reforms alone are not enough. It is important that they have a long-term impact on growth" , she said.

  " The timeframe of our negative outlook is two years. This means Italy's outlook can change over the next 24 months. If Italy goes in the right direction, we will take this first step," she said.

  The arrival of the government led by Mario Monti had avoided a downgrade worse than the one S& P had carried out, she said.

  Italian Prime Minister Monti's government has launched austerity measures and a deregulation package meant to cut costs and boost growth in the euro zone's third-largest economy.

  Also in January, rating agency Fitch downgraded the sovereign credit ratings of Belgium, Cyprus, Italy, Slovenia and Spain, indicating there was a 1-in-2 chance of further cuts in the next two years.

  Fernandez de Heredia said S& P was not negative on the euro and the euro zone.

  " What disappointed us was the response of European policies to the crisis," she said. (Reporting By Stephen Jewkes, Antonella Ciancio)

-- Clyde Russell is a Reuters market analyst. The views expressed are his own. --

 

  By Clyde Russell

  SINGAPORE, March 2 (Reuters) - It's encouraging to see Indonesia taking tentative steps towards cutting its overly generous fuel subsidies, a move that will hopefully inspire other Asian nations to do the same.

  While China grabs the headlines as the main driver of rising global oil consumption, demand in other Asian nations is also climbing in contrast to steady-to-lower usage in North America and Europe.

  However, it's too early to get excited and say the growth in non-China Asia's oil demand is about to slow because governments are feeling the fiscal pinch of providing subsidies.

  But it is worthwhile to encourage the trimming, or even the elimination, of subsidies so that Asian consumers can feel the effects of the movements in global crude prices.

  Currently, adjusting the global supply-demand balance in response to changes in prices is largely left to consumers in North America and Europe, but this would change if Asians were fully exposed to crude prices.

  This would help the market adjust quicker by making demand destruction appear earlier when prices spike, as they have done in recent weeks with investors fretting about the potential loss of Iranian supplies.

  Looking specifically at Indonesia, the government has two proposals before lawmakers: the first would increase prices by a flat 33 percent and the second would allow floating prices with a fixed subsidy of 2,000 rupiah (22 cents) a litre.

  The first option is said to be the front runner, and would lift the gasoline price to 6,000 rupiah, or 66 cents, a litre.

  However, this would still be a heavily subsidised price: 92-RON gasoline in Singapore traded at the equivalent of 83 cents a litre yesterday, which is a free-on-board price that doesn't take into account the cost of transportation and any retail margin.

  Even after trimming the subsidy, Indonesia would still have the second-cheapest gasoline in Asia behind Malaysia at 60.7 cents a litre.

 

  China has lowered subsidies in recent years and its gasoline price as of Feb. 8 was equivalent to 106 cents a litre, probably enough to ensure that refiners were able to squeeze a small profit from producing the fuel.

  India's gasoline price is also more market-related at 139 cents a litre, but its main fuel is diesel, which costs 91.1 cents a litre, just above the Singapore price of 83.7 cents but not enough for refiners to break-even once transport costs and retail margins are added.

  In Indonesia, India and Malaysia the rationale for subsidies to aid the poor has been eroded by the rise of the middle class and their love affair with cars.

  The subsidies mainly end up benefiting people who don't really need them, and this makes them even more difficult to remove as the middle class exercises more political hegemony than the poor.

  But even if the subsidies were trimmed or removed, how much would demand get crunched?

  Indonesia consumed about 1.3 million barrels of oil a day in 2010, according to the BP Statistical Review of World Energy.

  However, there is an incredibly wide range of estimates as to what the price elasticity of fuel demand is, and most research focuses on developed economies, making its relevance to fast-growing developing nations in Asia questionable.

  Some put the elasticity as high as 50 percent, some as low as 2 percent, and the impact of price changes also varies over time.

  This means estimating how much demand will fall because of Indonesia's proposed 33 percent fuel price hike is tricky and little better than guesswork.

  However, in the interests of debate, let's assume that the price hike goes ahead and elasticity is 20 percent, that is, for every 10 percent increase in the price, demand falls by 2 percent.

  A 33 percent hike in fuel prices would therefore imply a 6.6 percent drop in Indonesia's fuel demand, equivalent to a decline of about 86,000 barrels a day.

  This potential drop is fairly significant, given that the International Energy Agency expects demand from Asia, excluding China, to grow by 200,000 barrels a day to 10.9 million in 2012,

  Even though this is all speculation, the reaction of Indonesians to any fuel subsidy cuts will be key to working out the impact on demand.

  It's also certain that politicians from countries such as Bangladesh and Vietnam will be watching to see if Indonesia can trim subsidies without copping too much public anger.

* Boosting fund supply alone won't beat deflation-Shirakawa

  * Group of lawmakers submit list of demands to BOJ

  * BOJ seen extending loan scheme for growth sectors (Adds lawmaker proposal, deputy governor quotes)

  By Leika Kihara and Rie Ishiguro

  TOKYO, March 2 (Reuters) - Bank of Japan Governor Masaaki Shirakawa said consumer prices will gradually rise in the coming years, but that has not kept a group of ruling party lawmakers from demanding a higher price goal and further monetary stimulus in March.

  Shirakawa said that while consumer inflation is currently flat, it will gradually pick up as the economy recovers due to a rebound in global growth and domestic fiscal spending for reconstruction from last year's earthquake and tsunami.

  " We will continue with monetary easing until consumer inflation of 1 percent is in sight," he told a parliamentary committee on Friday, adding that price rises driven by temporary factors such as a spike in crude oil costs alone would not trigger a reversal of the bank's ultra-loose policy.

  He also stressed that while monetary policy eventually determines the long-term trend for prices, boosting central bank fund supply alone would not immediately push up prices and that deregulation and other measures to lift productivity were also needed.

  The yen fell and Tokyo stock prices rose after the BOJ increased asset purchases by 10 trillion yen ($123 billion) and set an inflation goal of 1 percent in the face of political pressure, signalling a more aggressive monetary policy.

  But some politicians are keeping up the pressure. A group of ruling party lawmakers on Friday submitted to Deputy Governor Kiyohiko Nishimura a list of proposals including calls for it to ease policy again in March and set a higher inflation goal of 2 percent.

  It handed the same proposals to Seiji Maehara, the ruling party's policy chief, on Thursday.

  The list by the 75-member group, which includes former cabinet members, is unlikely to make much headway given Prime Minister Yoshihiko Noda has welcomed February's BOJ action and appears in no mood to pile fresh pressure on the bank.

  But it shows that despite February's action, some lawmakers feel the BOJ is not doing enough to address deflation. Many analysts expect the bank to come under even more pressure for action if the yen renews its rise or the economy loses steam.

  Japan's core consumer prices fell an annual 0.1 percent in January, marking the fourth consecutive month of declines, suggesting mild deflation may persist this year as lacklustre wage growth curtails domestic demand.

  Having just eased policy last month and with the yen off record highs, the BOJ prefers to stand pat on monetary policy at its next rate review on March 12-13. It is instead expected to extend a separate loan programme aimed at encouraging banks to lend more to industries with growth potential.

  Deputy Governor Nishimura, appearing in the same parliamentary committee as Shirakawa, said the loan scheme proved effective as an impetus for banks to seek and nurture companies with potential.

  " The BOJ recognizes that boosting Japan's growth potential is extremely important so it will continue to implement the scheme appropriately," he said, signalling readiness to keep it in place beyond the March deadline.

  BOJ board member Hidetoshi Kamezaki also said on Wednesday that the scheme had been successful in nudging banks into lending more to sectors with potential such as clean energy and nursing care.

  In its latest long-term projections issued in January, the BOJ forecasts core consumer inflation of 0.1 percent in the year beginning in April and 0.5 percent the following year. It will review these forecasts in April. ($1 = 80.9800 Japanese yen) (Reporting by Leika Kihara Editing by Michael Watson)