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Originally published Monday, December 10, 2012 at 7:38 AM

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Italian election means new stress for eurozone

Until last weekend, Europe seemed headed for a quiet Christmas and New Year's. Then Italy's Prime Minister Mario Monti unexpectedly announced he was going to resign, pulling the plug on a government that had boosted confidence in the country's ability to manage its debts.

The Associated Press

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FRANKFURT, Germany —

Until last weekend, Europe seemed headed for a quiet Christmas and New Year's. Then Italy's Prime Minister Mario Monti unexpectedly announced he was going to resign, pulling the plug on a government that had boosted confidence in the country's ability to manage its debts.

The prospect of a return to a shaky government and finances has suddenly put new strains on the leaders of the 17-strong group of European Union countries that use the euro and their efforts to bottle up the region's debt and economic crisis.

Analysts warn that after several months of calm, the eurozone could now be in for a rougher ride as 2013 begins.

The concern is that, while the European debt crisis is not as bad as it was last summer, Italy's problems will spread and further unsettle other parts of the eurozone. Greece faces skepticism that it can keep paying its debts despite (EURO)240 billion in bailouts and Spain is still weighing whether to ask for a rescue from the eurozone's bailout fund.

Since it took office in November 2011 - after markets lost confidence in Premier Silvio Berlusconi's half-hearted attempts at reform - Monti's 13-month old government has managed to lower Italy's borrowing costs in the bond markets - albeit with help from the European Central Bank and its offer to buy short-term debt. His unelected cabinet of experts had until elections scheduled for April to implement reforms. Monti resigned earlier than expected after Berlusconi's party withdrew support for his government on Thursday.

Italy's borrowing costs started to rise again Monday morning as investors worried over who would keep the country on the path to recovery. The interest rate on Italy's 10-year bonds, a key indicator of the debt crisis, jumped to 4.75 percent. Last week they yielded only 4.4 percent - down from over 7 percent at the start of 2012. At one point during the day, Italian stocks slumped more than 3 percent.

"The uncertainty is significant, not just how the election will pan out, but how the government will turn out and what the debate is going to be like," said analyst Raoul Ruparel at the Open Europe think tank in London.

"And that's not something markets like. You add in the Greek uncertainty and Spanish uncertainty on top of that... and that's a worrying confluence of factors for a pretty fragile eurozone at the moment. "

The risk from Saturday's announcement is that heavily indebted Italy, the eurozone's third-largest economy after Germany and France, will now slow down or halt efforts to shake up its economy. The country's debt stands at 126 percent of its annual gross domestic product of (EURO)1.6 trillion ($2.1 trillion).

After passing a 2013 budget, the Italian parliament will likely pass little in the way of new measures for several months. And Italy could come out of new elections - expected in February - with no party clearly in control.

Meanwhile, the election campaign could see Berlusconi shake market confidence by campaigning on an anti-cuts platform. His party lags in the polls, however, and some analysts think a new government could be led by center-left candidate Pier Luigi Bersani, who has vowed to keep Italy's commitments to its EU partners.

Europe's crisis over too much debt was calmed when European Central Bank head Mario Draghi said in July that the bank would "do what it takes" to rescue the euro. He then followed up with a plan in September to buy unlimited amounts of government bonds issued by indebted countries, if they agree to reduce their deficits. The bond purchases would have to be preceded by a formal request for financial help from the European Stability Mechanism, the eurozone's bailout fund.

The purchases could push bond prices up and interest rates down, since prices and rates move in opposite directions. Just the possibility that the ECB might intervene had already sent borrowing costs down for Spain and Italy.

Monti's resignation raises the chance, analysts say, that the ECB will have to actually deploy its bond-purchase weapon. But without a stable government that can credibly agree to the terms of a bailout, Italy can't get help from the ECB bond purchase plan.

Still, markets knew Monti would be leaving soon anyway, with elections already scheduled in April. And if debt costs continue their rise, some think that could be the spur Italian politicians to move forward with pro-growth steps such as reducing legal protections against layoff for established workers. The practice deters hiring and raises youth unemployment. Monti made some changes, but was unable to push through wholesale reform in the face of union resistance.

Raj Badiani at IHS Global Insight said high bond market interest costs could "force the Italian political classes to refocus on the actions needed to push away intensifying" government debt pressures.

That's what happened in late 2011, when rising bond yields intensified fears Italy might default. Pressure from that helped force Berlusconi to resign - and make way for Monti.

"The slightly scary thing is, it's easy to see how it can get significantly worse and continue to do so, but it's very hard to see how things could possibly surprise on the upside," said Sony Kapoor, managing director of think tank Re-Define. "So I think the best-case scenario is that the change in the political scene will reflect badly on the economy - but not too badly."

But, warns Kapoor, if "Berlusconi does come back and the old discredited guard of Italian politics comes back, things could get significantly worse rather quickly."

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