Euro zone back at a crossroads as Italy wonders which way to go

Should Italian voters return Silvio Berlusconi to power, investors' fragile optimism will likely be shattered and the currency bloc's fast-forgotten crisis will flare up.

Supporters of the Italian centre-left Democratic Party, above, demonstrating in Naples last week, hope to prevent a return to power by Silvio Berlusconi, who is widely seen as a threat to market stability in the euro zone. Mario Laporta / AFPShow less

Should Italian voters return Silvio Berlusconi to power rather than elect to continue upon a path of technocratic reform, investors' fragile optimism will likely be shattered and the currency bloc's fast-forgotten crisis will flare up. David Crossland, Foreign Correspondent, writes from Berlin

Remember the euro crisis? It could rear its head again if the Italian election taking place today and tomorrow produces a political stalemate in the euro zone's third-largest economy. And in the unlikely but possible event that voters hand a fourth term to the eccentric media tycoon Silvio Berlusconi, 76, the crisis would be back with a vengeance.

With technocrat Mario Monti at the helm as interim prime minister since November 2011, markets have grown confident that Italy was finally getting to grips with its problems.

Bond yields, all-important because Italy must service a public debt of more than €2 trillion (Dh9.7tn), or almost 130 per cent of its annual GDP, have declined from the record levels above 7 per cent reached in 2011. Back then, the world feared that Italy, too big for its partners to bail out, might drag the euro down with it.

Calm may have returned, but it has been uneasy. While Mr Monti won international praise for introducing austerity measures based on steep tax hikes that have contained the budget deficit, he has made little real progress on the economic reforms urgently needed to generate growth.

As a result, the Italian economy remains on very shaky ground. The latest data shows that GDP shrank by a higher-than-expected 0.9 per cent in the fourth quarter, continuing a recession that has plagued the country since mid-2011.

Adding to Italy's problems, the financial system is being rocked by fraud and bribery allegations surrounding its third-biggest bank, Monti dei Paschi di Siena. The scandal has raised questions about Italian banking supervision and about the future of Monte dei Paschi, which won final approval last month for a €3.9 billion state bailout.

Prosecutors are investigating the bank's acquisition of smaller rival Antonveneta from Spain's Santander in 2007 as well as a series of loss-making derivative and structured finance trades that occurred between 2006 and 2009.

But the biggest economic risk is the prospect of a comeback by Mr Berlusconi, or of an outcome that would give him enough political power to thwart the formation of a stable, reform-orientated government.

"I think the Italian election could be a potential trigger for the euro-zone unrest to come back," says Peter Vanden Houte, the chief euro-zone economist at ING. "The markets would immediately punish the outcome with higher bond yields because they have not forgotten what happened when Berlusconi was last in power. We might see a repeat of the tensions on the bond market.

"Even if Berlusconi doesn't win, the outcome may not be positive for the markets given the fact that it might take some time before a government is formed, and it's far from sure that a leftist coalition would be powerful enough to continue a reform agenda."

So great are international fears of a Berlusconi comeback that German politicians have taken the unusual step of warning Italians not to elect him. "Silvio Berlusconi may be an effective campaign strategist," an Italian news magazine last week quoted the German finance minister Wolfgang Schäuble as saying. "But my advice to the Italians is not to make the same mistake again by re-electing him."

New political instability in Italy would heighten fears among investors who are already unsettled by Europe's inability to agree on a bailout for Cyprus and by a kickbacks scandal that has engulfed the Spanish government and kept the nation's finances in disorder.

"My feeling is that the markets seem overly optimistic on the euro zone," says Mr Vanden Houte. "Non-European investment funds, for example American ones, have come back to the European market saying you have to buy Italy and Spain and other peripherals because the European Central Bank will help out, whatever happens. That's a bit too optimistic."

But Mr Vanden Houte said the pledge by the ECB president Mario Draghi last July to do "whatever it takes to preserve the euro", was likely to prevent a repeat of a market flare-up on the scale seen in the first half of last year.

At this point, Mr Berlusconi looks unlikely to be able to crown himself a fourth time, even though he has been scoring points with promises of sweeping tax cuts and a pledge to refund a tax on first homes imposed last year by Mr Monti's government.

Opinion polls show Berlusconi's centre-right coalition in second place, slowly catching up with the centre-left alliance of the front-runner Pier Luigi Bersani, who wants to win more spending leeway from the EU and ease the effect of austerity on workers.

Mr Monti, an economics professor, is not a consummate campaigner and his centrist alliance is trailing fourth in polls, possibly because he has promised voters more of his bitter medicine.

"Italy needs radical reforms. Radical reforms for those who are outside protected interest groups, and for young people who cannot find work because others are over-protected," he said at the launch of his campaign last month.

That is an area where he has been thwarted so far. A number of Italian sectors ranging from energy suppliers to taxis are shielded by rules that make it very difficult to hire and fire workers.

As prime minister, Mr Monti hoped to boost the employment rate and lessen protection for older workers, who enjoy much better labour rights than millions of mostly young people in temporary jobs.

But he ran into opposition from Mr Bersani's centre-left Democratic party, which he relied on for his majority.

The ideal outcome for Europe would be a win for Mr Monti, but that looks highly unlikely. The second best would be a Bersani-Monti coalition strong enough to allow Mr Bersani to jettison a far-left party from his alliance.

Despite his calls to ease austerity, Mr Bersani has a solid record as a reformer - he eased labour restrictions and cut red tape as the economic development minister between 2006 and 2008. If Mr Monti were to become Economy Minister under him, confidence in Italy's prospects would remain strong, say analysts.

After all, the country has a strong and diversified industrial base, mainly located in the rich north.

Italy could creep out of recession this year if the euro-zone economy picks up, something the latest forecasts are doubtful about. Its long-term growth is destined to remain sluggish unless it reforms its structures.

A recent study by the IMF concluded that product- and labour-market reforms in Italy could unlock slumbering potential in the economy, raising GDP per head by 5.7 per cent in five years' time and by 10.5 per cent in 10.