By James Mackenzie
ROME (Reuters) - European partners heaped praise on outgoing Italian Prime Minister Mario Monti on Monday, and called for the next government to stick to his reform agenda after his surprise decision to resign rattled financial markets.
Monti's weekend announcement that he would step down early - made after former Prime Minister Silvio Berlusconi's PDL party withdrew its support for his technocrat government - pushed up Italy's borrowing costs and prompted a stock market sell-off.
The campaign for an election expected in February is likely to be fought over Monti's reform agenda, which Berlusconi said had condemned Italy to recession and forced him reluctantly to run for a fifth term as prime minister.
By contrast, senior Europeans warned that Monti's policies must continue to prevent a return of the crisis which brought him to power a year ago to avert a Greek-style collapse.
"Monti was a great prime minister of Italy and I hope that the policies he put in place will continue after the elections," European Council President Herman Van Rompuy said in Oslo, where he was part of a European Union delegation receiving the Nobel Peace Prize.
The comments echoed similar remarks in the past two days from European policymakers ranging from French Foreign Minister Laurent Fabius to the head of the European bailout fund Klaus Regling and European Commission President Jose Manuel Barroso.
Spanish Economy Minister Luis de Guindos warned that instability in Italy could spill over and put Spain's fragile public finances at risk of further turmoil.
After several weeks of calm, markets bridled at the prospect of Berlusconi's return to lead the center-right, just over a year after a financial crisis drove the scandal-plagued billionaire from office to be replaced by Monti's technocrats.
Opinion polls suggest Berlusconi has little chance of re-election. The center-left Democratic Party (PD) under Pier Luigi Bersani holds a strong lead and is likely to form the next government on a broadly pro-European platform, largely in line with Monti's agenda.
Berlusconi's strategy appears more designed to ensure he retains influence in the next parliament with a substantial voting bloc that, among other things, can protect his business and personal interests.
The main measure of investors' confidence, the spread between Italian 10-year government bonds and their lower risk German equivalent, widened to 362 basis points from 325 late on Friday, reflecting worries over a return to the political uncertainty which dogged Italy last year.
Milan's blue-chip share index dropped over 3 percent, with sharper falls in banking stocks that are seen as most vulnerable to a renewed debt crisis.
"You can expect a sharpening in anti-austerity, anti-reform rhetoric...and this will probably translate into a higher risk premium on Italian assets," said Goldman Sachs analysts Silvia Ardagna and Francesco Garzarelli.
Much attention has now focused whether Monti will enter politics himself, either as a candidate or by endorsing one of the centrist forces that have backed his reforms and made more or less explicit pleas for him to run.
The daily La Repubblica quoted the 69-year-old former European Commissioner as saying that he had not yet made up his mind but was worried by the situation. "I don't know," he was quoted as saying. "If I had to ... describe my feelings today, I would say that I am very concerned."
Monti's decision to resign once the 2013 budget is approved, probably before Christmas, has brought forward to February an election that had already been expected in March or by the latest April.
But it was Berlusconi's reappearance on the frontline and the prospect of a messy anti-Monti election campaign which galvanized attention in both Italy and abroad, reawakening memories of the financial and sexual scandals that plagued the media magnate's last government.
The Roman Catholic Church made outspoken and thinly veiled criticism of Berlusconi that may influence the PDL's traditional conservative voting base.
"What leaves one astonished is the irresponsibility of those who think of arranging things for themselves while the house is still burning," the influential head of the Italian bishop's conference, Angelo Bagnasco, told the Corriere della Sera.
With a new government likely to be formed in a few months, Italy's European partners have now started to look more closely at Bersani, the overwhelming victor in a center-left primary election last month.
A no-frills former communist who is close to Italy's unions, Bersani has promised to stick to the promises on fiscal discipline the government has made and has said that Monti is likely to continue playing a role after the election.
While Italy's election laws are likely to give Bersani a strong majority in the lower house, the complicated rules may make it more difficult for him to take control of the Senate, posing a possible risk to the formation of a stable government.
Whoever wins will have to confront a severe recession, record unemployment and a ballooning public debt expected to surpass 126 percent of gross domestic product this year.
The depth of the crisis was underlined on Monday, with data showing GDP shrinking 2.4 percent in the third quarter and industrial production dropping 1.1 percent in October.
(Additional reporting by Luke Baker and Balazs Koranyi in Oslo, Lisa Jucca, Silvio Aloisi, Giancarlo Navach, Alessia Pe, Maria Pia Quaglia in Milan; editing by Barry Moody and David Stamp)
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