German Chancellor Angela Merkel praised Italy's new government on Wednesday for the speed with which it has launched reforms, prompting Prime Minister Mario Monti to say it was important for markets also to recognize Italian economic policy progress soon.

Merkel said at a joint news conference with Monti in Berlin that his technocrat government had been quick to launch urgent budgetary measures and now structural reforms aimed at making the Italian economy more competitive in order to boost growth.

This will strengthen Italy, said Merkel on Wednesday.

Monti, while thanking the Italian people and parliament for what he called their mature response to very painful reforms, said his country could only make further progress within a more helpful European environment, including cheaper borrowing.

The European context must become more favorable, by permitting in good time a lowering of interest rates and greater integration of the EU, said Monti.

Italy still faces 10-year borrowing costs of around 7 percent, widely viewed as unsustainable for an economy saddled with a debt of around 120 percent of GDP. Rome must refinance tens of billions of debt in the first four months of the year.

In the financial markets, high interest rates could have been justified when markets were diffident about Italian economic policy, but not anymore, especially after representatives of those same markets have said they appreciated the efforts made, Monti said.

It was up to Europe to facilitate the transformation of good policies into lower interest rates, he said.

Speaking to investors in Frankfurt, a top ratings agency analyst said Italy needed more robust support from the European Central Bank in terms of buying its bonds. Both the ECB and Germany are deeply reticent about such action.

It is hard to believe the euro will survive if Italy does not make it through, said David Riley, the head of sovereign ratings for Fitch, adding that while many saw Italy as too politically and economically important to be allowed to fail, one might also argue that it is too big to rescue.

The warning pushed the euro down to within touching distance of a new 16-month low versus the dollar.

Merkel's personal relations with Monti's predecessor, Silvio Berlusconi, were very tense and she and French President Nicolas Sarkozy took a tough stance on his reluctance to begin spending cuts once Italy became a focus on market speculation about the euro zone debt crisis spreading from Greece.

Monti told Merkel Europe no longer has to fear Italy as a possible source of contagion for the euro zone, but can count on Italy to play its proper role beside Germany and France and other countries in the drive for stability and growth.

The premier, a former European Commissioner appointed in November to try to reassure markets Italy can manage its debt mountain, confirmed Merkel and Sarkozy would visit him on January 20 to see for themselves the reforms his government has begun.

TOBIN TAX MUST BE EU-WIDE

Merkel made clear the euro zone's top priority at the start of 2012 was to secure a second aid package for Greece, an issue which needed to be resolved before Europe could start working out how to boost growth and jobs.

That hangs on finalizing a deal for private creditors to take a 50 percent writedown on their Greek bondholdings, which remains elusive with time running short.

The euro zone's first obligation this year is to resolve a second Greek program and finalize these negotiations with the banks so that we can then concentrate on structural problems in the euro zone, Merkel told the news conference with Monti.

She also said Germany would be prepared if necessary to pay more capital up front into the euro zone's permanent bailout mechanism, the ESM, which is due to come on stream in the middle of the year. The statement helped the euro claw back some losses and German Bund futures retreat from the day's highs.

The Merkel comments about Germany being ready to put more money into the ESM ... seem like a change of tack. It seems a more proactive approach to the crisis, a bond trader said.

Both leaders played down the option, pushed by Sarkozy who is seeking re-election this year, of a new financial transaction tax in the euro zone rather than the whole European Union if non members of the currency zone, like Britain, keep opposing it.

Monti said he was once a student of Nobel laureate economist James Tobin, credited with the transaction tax idea in the early 1970s, but that Italy saw it only on a global or EU scale. I'm not sure it makes sense only at euro zone level, said Monti.

Merkel, whose own conservatives back the euro zone going it alone with the tax but lack the support of their Free Democrat (FDP) coalition partners for this, backtracked on comments made on Monday about the tax maybe applying to just the euro states.

She said Berlin would push for the tax through the EU for now, rather than just the euro zone, because the government cannot represent that position, no matter what I said before.

In an earlier interview with German daily Die Welt, Monti had said Italy needed help to reform, otherwise it could fall prey to anti-European populists.

I cannot be successful with my policies if the policies of the EU do not change. If that doesn't happen, Italy -- which has always been a pro-European country -- could flee into the hands of populists, he was quoted as saying.

(Additional reporting by Andreas Rinke in Berlin, Marc Jones in Frankfurt and Steve Scherer in Rome; Writing by Stephen Brown; Editing by Noah Barkin/Mike Peacock)

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