Pressured Berlusconi To Quit As Italy's PM

Italy's Prime Minister Silvio Berlusconi agreed Tuesday to resign after new austerity measures are approved, raising hopes that the indebted nation will carry out reforms, but some fear that a change of government will not fix the problem.

Earlier, Berlusconi officially won a key budget vote due to opposition abstentions, but failed to get an absolute majority in the lower house of parliament.

That sent the Italian 10-year bond yield soaring to yet another high of 6.77% from 6.66% on Monday and 5.87% on Oct. 27, when euro zone leaders agreed on a new debt crisis plan. That is an unsustainable level. The 7% mark was a rough trigger for bailouts of Portugal and Ireland. But the euro zone can't bail out Italy, the bloc's third-largest economy.

Word that Berlusconi would resign came after European markets closed. But the news fueled U.S. stocks in the afternoon. The S&P 500 and Nasdaq both closed 1.2% higher, near session highs.

One scenario is former European Commissioner Mario Monti stepping in to head a technocratic government to carry out labor and pension reform, privatization of state property, and growth-boosting measures.

But if elections take place and another fractious government steps in, investors fret that Rome will not make any progress .

Key to the unfolding drama, analysts say, has been the European Central Bank's policy of buying Spanish and Italian bonds in the secondary market. One question is whether the ECB, which has apparently slowed the pace of its securities market program (SMP), resumes bond purchases with Berlusconi on the way out.

"There will likely be a short relief rally in stock markets, and the Berlusconi political risk premium embedded in Italian yields will likely disappear," said IHS analyst Jan Randolph. "But Italy will not be out of the heat of bond markets until a solid and stable government actually implements austerity and undertakes reforms with strong credible leadership. Only after this happens will the ECB come in to support Italian bonds, rewarding measures taken to improve creditworthiness.

Italy's Mario Draghi now heads the ECB, but Germany opposes the bond-buying, which reduces the borrowing costs of debt-laden countries. Berlin says it gives Italy and others less incentive to make economic reforms. Italy must roll over an estimated 15 billion euros ($20.7 billion) in debt over the next month.

With many economists saying Europe is heading into a recession, a sustained hike in financing costs coupled with slowing GDP growth could doom Italy, which many analysts say is too big to bail out through the European Financial Stability Facility.

"Berlusconi has been a yoke and a joke. He has to go," said economist Ed Yardeni. He added that the "ECB needs to continue buying Italian bonds" despite German resistance.

ECB holdings of euro-area securities has jumped to around 571 billion euros, including about 80 billion euros in Italian debt.

"As long as the ECB intervenes in the secondary market whenever Italian yields rise above 6%, we believe Italy loses the incentive to proceed with economic reforms and structural adjustment," said Merrill Lynch economist Laurence Boone in a report out Tuesday.

"Unless there is a change in policy in Italy, we believe it is unlikely to deliver on reform," he said. "At the same time, the ECB does not want to run the risk of Italy's rising yields spilling over to France and putting the whole EFSF in jeopardy.

Boone says continued ECB bond-buying will be tied "tit-for-tat" with reforms delivered by Rome.

France on Monday unveiled new austerity measures to try to keep its AAA credit rating.

Critics of Europe's debit crisis response point to the lack of backstop akin to the Federal Reserve. Draghi has said the 2007 Lisbon Treaty does not let the ECB act as lender of last resort to governments.

Yardeni, though, says the ECB has "engaged in a stealth program of quantitative easing." He says the ECB's balance sheet has shot up by 327 billion euros since July to 2.33 trillion euros.

Germany and France brokered a deal to hike Europe's bailout fund — the EFSF — to 440 billion euros in July. In late October, European leaders unveiled yet another plan to boost the EFSF to more than one trillion euros, but global markets have been shaken by political turmoil in Greece and Italy. (Greek political leaders are in talks for a new unity government.) Also, European leaders seemed to be hoping that they could convince China, the IMF and private sources to pony up the extra trillion euros. But the G-20 offered no new cash last week, China's sovereign wealth fund chief said this week that Europe encourages "sloth" and "indolence" while financial firms have been loudly publicizing their reduction in European exposure.

Still, while Italy has Europe's second highest debt-to-GDP ratio, some analysts say it can rebound.

Unlike Greece, household wealth is relatively high, making reforms more digestible. Italy's new budget relies heavily on new taxes.

Italian banks are less exposed than Greek banks to national debt. Italy also runs a primary budget surplus, excluding debt interest, says Northern Trust economist Paul Kasriel.

"When you're running a primary surplus, at least you're making progress, but it may be that interest will be too overwhelming," he said.

With Europe slipping into what he says will be a "mild recession that persists," Kasriel says the ECB must change its stripes as European banks write down debt.

"We're very likely going to see contractions in bank credit," he said. "The ECB needs to step in and provide credit that the banking system isn't able to provide while it's recapitalizing. But it appears to have no inclination to do that."