Italy flirts with a Berlusconi bungle

Silvio Berlusconi has never been one to stay out of the limelight, but his decision to run for the prime ministership again, and the inevitable instability it will bring to Italy, will have dismayed many of Europe's leaders who must surely have thought they were over the worst of the crisis.

Investors will also be loath to see the return of Berlusconi, whose many controversies often distracted from his role as prime minister of the third largest economy of the region.

Forced to step down just last November amid a crisis that saw financial markets lose all confidence in the country, Berlusconi has been vocal in his criticism of the austerity program brought in by the current technocratic government, headed by respected economist Mario Monti.

Monti's announcement over the weekend that he would resign once parliament approves next year's budget came after Berlusconi's People of Freedom Party withdrew its support for the government. With the possibility of Berlusconi back at the helm, investors are right to be worried.

Markets sank on Monday, with the FTSE MIB quickly diving 2.3 per cent at the open, and eventually closing 2.2 per cent lower. Meanwhile, the yield on Italian 10-year sovereign bonds jumped as much as 38 basis points to 4.9 per cent, the highest since August, before settling back down at 4.75 per cent. The spread between Italian and German bond yields widened to 360 points.

Part of the reason investors are rattled is because many believed Italy was back on track in recent months, and they had gone from being underweight in both Spain and Italy to being neutral or overweight. Monti's decision to step down is the last thing investors were expecting, and many will have been caught exposed.

Italy wasn't the only casualty of the move, with Spanish bonds also hit as fears grow that Spain will suffer contagion from developments in Italy. Overnight, the spread between Spanish and German 10-year bonds rose to 4.27 per cent. The yield on its 10-year bonds rose 10 basis points to 5.5 per cent. Spain is already in a fragile state, having negotiated a bailout for its banks mere months ago. If the turmoil continues, the eurozone could be plunged into the biggest crisis yet.

The response by financial markets shows the extent of the risk that Berlusconi is taking and the threat he and his party pose to the stability of the country, and the region.

Berlusconi stepped down just over a year ago after losing his parliamentary majority. He has since been convicted of tax fraud and is currently on trial for alleged sexual misconduct and abuse of power. The latest bid for the prime ministership will be the sixth in Berlusconi's career, and fourth successful run if elected. But his last time in office did little to address a decade of stagnant growth and rising debt and was marred by erratic, off-colour remarks, including inflammatory comments about Angela Merkel's appearance which ignited a fresh controversy just before he stepped down.

Berlusconi's wild flip-flopping on Italy's future in the eurozone will also contribute heavily to investor concern if he succeeds in being elected as prime minister. Just last June, he suggested Italy should consider leaving the eurozone unless Germany agreed to the ECB acting as a guarantor for sovereign debt and printing money to shore up the economy. Then in August he said that an Italian exit from the eurozone would be a disaster.

This time around, Berlusconi will be banking on riding to victory on the backlash the current government has faced since implementing a number of austerity measures. He has been quick to lay the blame with Monti, complaining that his policies have put the country into a "spiral of recession".

A Berlusconi campaign will centre on anti-austerity promises, which will win over the public but will do nothing to solve the country's problems or instil investor confidence. If Berlusconi has his way, all the work that the current reform-focused government has done to improve the country's standing on the international stage will have been for nothing.

But he could be in with a shot given the increasingly negative attitude from the electorate toward Monti. There was even a ‘No Monti Day' held last September that saw thousands of Italians protest against spending cuts, tax hikes and soaring unemployment.

The austerity policies have come at a cost to growth, and Italy's debt-to-GDP ratio continues to rise. It is currently the second highest in the eurozone, at 126 per cent, behind Greece at 150 per cent.

But these measures have also given financial markets renewed faith in Italy's future and have brought bond yields down to more sustainable levels. Monti's policies have been aimed at getting a handle on the country's staggering debt and persuading other European leaders to allow the Italian economy breathing space to grow. When he took over, Italy was on the brink of bankruptcy and threatened to bring the euro down with it. He has, within the confines of the options available, at least given Italy, and Europe, what was needed most – a sense of stability.

Investors and politicians will be hoping that Monti makes the decision to go up against Berlusconi in next year's election. A return by Berlusconi to office would be a disaster for the country's stability. But Italy has the chance to finally turn away from Berlusconi and his populist antics that can only bring the country into further disarray.