MILAN - Talks have started on a possible merger between Spain's Telefonica and its smaller partner Telecom Italia, Italian sources close to the matter said.

Both the Spanish company and the Italian government remain cautious about a deal, they said, with one source adding no transaction was likely before regional elections in Italy at the end of March.

Telecom Italia shares turned positive and gained as much as 1.5 percent after the comments. They were up 0.1 percent at 1.092 euros at 1245 GMT (7:45 a.m. EST). Telefonica shares were unchanged.

What the outcome will be is difficult to say. The truth is that the talks are still at a preliminary level, the source said. The issue is being discussed but it will be difficult to have a decision before the regional elections.

Telefonica declined to comment.

Speculation about a deal between the companies has heated up in recent weeks, spurring a rally in Telecom Italia stock but drawing opposition from politicians in Rome who are wary of allowing the country's phone network to fall into foreign hands.

Telefonica is the biggest shareholder in the Telco investor pact that controls Telecom Italia and has long been considered a logical buyer for the company, though a green light from Rome would be essential for any deal.


The source played down recent comments from Prime Minister Silvio Berlusconi's government on a free-market approach, suggesting a hands-off policy.

The most accurate reading at the moment seems to be that the government is giving the appearance of openness toward a tie-up, in response to certain pressures from Spain, and which have to do with other Spanish dossiers, the source said.

An Italian source close to the matter previously said Italian banks were lobbying for a tie-up between Spain's Abertis and Italy's Atlantia to set the stage for a reciprocal takeover of Telecom Italia by Telefonica.

A second source said that the government is worried about political attacks over not saving the Italian identity of Telecom Italia in a deal, especially after it blocked the sale of airline Alitalia to Air France-KLM.

Telefonica also is moving cautiously because of Telecom Italia's large debt load, while Italian investors in Telco may be willing to exit or become shareholders in the new combined group, the first source said.


Latin America, where the two companies have overlapping operations, could be a bigger hurdle.

Faced with antitrust issues, Telefonica would probably try to retain Telecom Italia's Tim Brasil unit rather than Brazilian telecom Vivo, which it controls along with Portugal Telecom, said the first source.

A third source said the combined group would prefer to control Tim Brasil rather than half of Vivo, which is Brazil's largest mobile phone carrier.

(Additional reporting by Robert Hetz in Madrid, Writing by Deepa Babington; editing by John Stonestreet)