Italian markets hit as Draghi government crumbles before ECB rate hike



* Draghi resigns

* Italian borrowing costs jump, but off recent highs

* Stocks fall, bank shares down 4%

* ECB set to hike rates later on Thursday

By Dhara Ranasinghe

LONDON, July 21 (Reuters) - Italian bond and stocks sold off sharply on Thursday following the collapse of Mario Draghi's government, just as markets braced for the first interest rate hike from the European Central Bank since 2011.

Benchmark 10-year Italian bonds yields soared more than 20 basis points (bps) to their highest since June 28 and Italian lenders .FTITLMS3010 slumped 4%, with renewed political uncertainty coming at a time of a darkening economic growth outlook and higher borrowing costs.

"It is a big blow to Italy's ability to deliver policies and reforms over the near term," said Lorenzo Codogno, head of LC Macro Advisers. "There will be delays and disruptions with early elections, and most likely no budget by year-end."

Italian stocks .FTMIB shed 1.3%, while broader European shares rose 0.2%. Lenders UniCredit CRDI.MI and BPER Banca EMII.MI slid between 4% and 5.8%.

Draghi's resignation after his national unity government fell apart set the country on course for an early election.

The euro trimmed its gains EUR=EBS and was last up just 0.09%, but it drew some support from expectations for a big ECB rate hike and news Russia had resumed pumping gas through its biggest pipeline to Germany.

Ten-year Italian bond yields rose to 3.70% IT10YT=RR before pulling back to 3.65%, up 18 bps on the day. That pushed the gap over top-rated German debt to almost 245 bps, a five-week high DE10IT10=RR .

"A renewed spike in yields could reignite market fears about a looming Italian debt crisis," Danske Bank strategists said in a note.

However, other analysts said Italy was in a better spot to weather the latest instability. The 10-year yield is some way off the 4% level breached in June just before the ECB held an emergency meeting to discuss bond market stress.

"Italy's Treasury is already pretty advanced with funding targets, so this government crisis does not catch it in a pressure situation," said Luca Cazzulani, a senior strategist at UniCredit.

BAD TIMING

Renewed political uncertainty in Italy, the euro area's third-biggest economy, comes just as the bloc's borrowing costs are set to rise.

The ECB is set to hike rates by 25 or 50 basis points on Thursday to fight record-high inflation.

The ECB announces its policy decision at 1215 GMT and the news conference is scheduled for 1245 GMT.

Most euro zone bond yields were modestly higher ahead of the ECB meeting DE10YT=RR .

The ECB is also expected to announce a new tool aimed at capping member countries' borrowing costs when they are deemed to be out of sync with economic reality.

The latest Italian political crisis could complicate implementation of a new programme.

"The market is holding up pretty well for now," said UniCredit's Cazzulani. But he said that if "the ECB message on the anti-fragmentation tool is weak today" then the gap between Italian and German bond yields could widen further.



Italian bond spread widens on political crisis Link
Italian PM Draghi resigns after coalition deserts him

NEWSMAKER-Italy's 'Super Mario' Draghi undone by political
infighting

ANALYSIS-Debt-laden Italy looks no less vulnerable as rates shoot higher



Reporting by Dhara Ranasinghe; additional reporting by Susan Mathew in Bangalore, Joice Alves and Saikat Chatterjee in London and Antonella Cinelli in Rome; Editing by Tommy Reggiori Wilkes, Kim Coghill and Alison Williams

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