The imminent end of Prime Minister Mario Monti's government fueled the largest increase in Italian borrowing costs in four months and threatened to open a new front in Europe's crisis fight before a year-end summit.

Italian 10-year bond yields jumped 36 basis points to 4.89 percent at 12:18 p.m. in Rome, widening the difference between yields on German bunds of similar maturity by 38 basis points to 361 basis points. Italy's benchmark FTSE MIB stock index fell 3.4 percent, while Germany's DAX Index slipped 0.6 percent.

Italy's government crisis, which pits Monti against billionaire former premier Silvio Berlusconi, is roiling investors and bringing tensions among European Union leaders to the fore. EU heads of state and government, gathering in Oslo today to collect the Nobel Peace Prize, are seeking to present a united front as the resurgent Berlusconi hits the campaign trail with his German-skeptic, anti-austerity message.

“The underlying cracks within the euro zone are actually widening,” Georg Grodzki, head of credit research at Legal & General Investment Management in London, which has about $290 billion of bond funds, said in an interview yesterday. “Investors will be reading Italian politicians' lips very, very closely.”

The Italian election campaign puts the EU's budget policy up for review in the 27-country area's fourth-largest economy. Monti, 69, said Dec. 8 he will resign due to parliamentary opposition from Berlusconi and his allies, who had previously backed the government. The unelected premier is undecided about whether to seek a second term, Italian daily La Repubblica reported today.

Monti will hand in his final resignation after making an attempt to muster parliamentary support for the 2013 budget law. A vote is due before the end of the year. Elections will be held 45 to 70 days after President Giorgio Napolitano dissolves parliament. In that interim period, Monti may remain premier, or Napolitano may appoint a caretaker.

Under Monti's 13-month-old government, Italy's 10-year bond yield has declined more than 200 basis points and the government last month sold debt at the lowest rate in two years. His austerity measures, while deepening the country's fourth recession since 2001, have also left the nation on track to bring its deficit within the EU's limit of 3 percent of gross domestic product this year.

Improved Image

“Italy's image has improved markedly thanks to the Monti government, and all that could be reversed,” Riccardo Barbieri, chief European economist at Mizuho International Plc in London, said in a research report today. Berlusconi “has repeatedly argued that the pros and cons of leaving the euro must be better analysed and considered.”

At a summit in Brussels on Dec. 13-14, EU heads of government will debate a road map for the overhaul of the euro area, including increased powers to intervene in national budgets and the establishment of a single banking supervisor. Finance ministers will meet first, on Dec. 12.

Finding consensus in the EU may become more difficult without Monti, who overcame German resistance at a summit in June to broker a common pledge to aid members in financial distress. Berlusconi, who was pushed from power last year after proving unable to protect Italy from the debt crisis, announced Dec. 8 he will seek the premiership in next year's election and criticized Monti for running a “German-centric” program.

“The 2013 Italian election remains high on our list of tail risks,” Holger Schmieding, chief economist at Berenberg Bank AG in London, wrote in a note yesterday. “A Berlusconi campaign against 'German austerity' could potentially unsettle markets.”

Italy's economy shrank 0.2 percent in the three months ended Sept. 30, the fifth consecutive quarterly decline. The economy contracted 2.4 percent on an annual basis and household spending fell 4.8 percent from a year earlier.

Italy faces about two months of campaigning as Berlusconi, 76, seeks to reverse an opinion-poll slide by disavowing his ties to Monti and appealing to an electorate weary of tax increases and recession. Berlusconi's People of Liberty party had 13.8 percent support in an SWG Institute poll released last week, compared with 30.3 percent for Monti's biggest remaining backer, the Democratic Party.

Legal Woes

Berlusconi, who was sentenced in October to four years in prison for tax fraud, is free pending appeal. In an unrelated case, he is standing trial on charges of abuse of power and engaging a minor in prostitution, allegations he has denied.

“The ability of Silvio Berlusconi to spook investors knows no bounds,” Nicholas Spiro, managing director of Spiro Sovereign Strategy in London said in an e-mailed message. “Mr. Berlusconi is not the cause of Italy's deep-seated and long-standing economic problems, but he epitomizes the dysfunctional nature of Italian politics, with its discredited leaders and unstable governments.”

Pier Luigi Bersani, head of the Democratic Party, won a primary election this month to head a coalition of center-left parties in general elections. Bersani's biggest challenge may come from the anti-austerity Five Star Movement of comedian-turned-politician Beppe Grillo, which had 19.5 percent support, making it the second-most popular party.

Bersani said in an interview published today by the Wall Street Journal that he would seek greater flexibility in EU budget rules, while confirming he would respect the covenants. Bersani has told voters he plans to ease portions of Monti's budget-saving pension reform.

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Monti&rsquo;s Exit Pushes Up Italy Yields

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