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LONDON, Dec 29 (Reuters) - Italy's borrowing costs fell to two-week lows on Thursday before a final bond auction of the year seen as a test of investor appetite for Italian debt as the country grapples with a crisis in its banking sector.
The Italian government is scheduled to sell up to 6.75 billion euros of debt at an auction later in the day.
That sale takes place at a time of intense focus on Italy's banking sector and the future of troubled lender Monte dei Paschi, which has requested aid from a new 20 billion-euro ($20.9 billion) state fund to help lenders in distress.
Efforts to clean up the banks and a smooth transition to a new prime minister, Paolo Gentiloni, have helped Italian bonds recover from losses made in the run-up up to a Dec. 4 referendum, in which voters rejected proposed constitutional reforms. Matteo Renzi quit as premier after that vote.
Still, there are concerns about the strength of the bailout fund. Earlier this week, the European Central Bank told Monte dei Paschi its capital shortfall had risen to 8.8 billion euros from the 5 billion euros indicated previously, raising questions about whether funds earmarked by the government would be enough to cover the requirements of the sector.
The link between Italy's banks and bond market is a major concern for investors. Banks, which hold large amounts of government debt, have been hit by worries over their exposure to bad loans built up during years of economic downturn.
"The auction should be a test of investors' appetite for BTPs," Luca Cazzulani, a strategist at UniCredit, said in a note. "Italian bonds were under pressure in November and the spread versus Bunds, although down from recent peaks, is still wide compared to the last two years average."
Italy's 10-year government bond yield fell 5 basis points to 1.79 percent, a two-week low.
Yields on safe-haven 10-year German bonds, which have benefited this week from concerns about Italy's bank rescue plan, fell to a fresh seven-week low of 0.17 percent .
But with Italian bonds outperforming, the 10-year yield gap over German peers narrowed to around 162 basis points. It had widened to just above 190 bps ahead of the Dec.4 referendum. (Reporting by Dhara Ranasinghe; Editing by Keith Weir)