Italian political crisis kicks off campaigning as markets watch

(Reuters) - Italian Prime Minister Mario Monti's imminent resignation has set off campaigning for an election expected in February, with financial markets on edge at the prospect of a return to an old-style Italian political crisis.

On Saturday the 69-year-old former European commissioner unexpectedly struck back against Silvio Berlusconi's People of Freedom (PDL) party which opened the crisis by withdrawing support from his government last week.

After meeting President Giorgio Napolitano on Saturday, he announced he would resign as soon as the 2013 budget is passed.

The vote was already scheduled for no later than April and Monti's move likely will bring it forward to February, but it may unnerve markets especially since Berlusconi announced his intention to seek a fifth term as prime minister.

Berlusconi was forced to resign during a ballooning euro zone debt crisis that had pulled Italy into its vortex while his government put off needed reforms, and amid a sex scandal involving pole-dancing prostitutes at his "bunga bunga" parties.

Opinion polls give the 76-year-old billionaire little chance of success, with the centre-left Democratic Party (PD) under Pier Luigi Bersani holding a strong lead. But the campaign could renew uncertainty about Italy's commitment to reform.

A former communist who is close to Italy's unions, Bersani has promised to stick to the promises on fiscal discipline the government has made to European partners and has said that Monti is likely to continue playing a role after the election.

The main barometer of investor confidence, the yield on the 10-year Italian government bond, stood at 4.5 percent at the end of last week. That was 323 basis points higher than the yield on the lower risk German equivalent, but well below the 7.3 percent peak hit last year when the spread with German Bunds hit 550 points.

The political manoeuvring will drive up Italy's bond yields, analysts said, but it may be short lived, especially if Monti makes clear that he will play a role in ensuring stability, either by returning to government or in a role such as president of the Republic.

"I can imagine that there will be a good deal of nervousness on the markets," commented one Milan investment banker.

"I wouldn't be overly worried because the elections are just one month earlier. A lot will now depend on Bersani's move, whether he can convince Monti to stay on," he said.

CRISIS

"We will see what happens," President Napolitano told reporters on Sunday when asked about how the financial markets would judge the sudden end of Monti's government.

The former European commissioner came to power at the height of the financial crisis a year ago and was widely credited with restoring Italy's credibility with investors and European partners after the scandal-plagued Berlusconi era.

"Monti has been able to do a lot in a short period of time, in particular on the fiscal side. I do not see any serious risk for the country," said Gian Maria Gros Pietro, a former chairman of oil giant Eni and a board member of carmaker Fiat.

Monti has set a target of balancing the budget on a growth adjusted basis in 2013 and says that much remains to be done to revive Italy's stagnant economy, the slowest growing in the euro zonefor more than a decade.

But Italians are heavily burdened by the recession, which began mid-way through last year and shows no signs of letting up. Many blame Monti's taxes for making it worse. Unemployment is at a record high and consumer spending has collapsed.

Aware of the economic climate, Berlusconi on Wednesday said Monti had taken Italy to the edge of an "abyss" and that his policies were causing an recessive spiral.

"Beware of Italian anger", the anti-establishment 5-Star Movement leader, comic Beppe Grillo, warned on Sunday in his blog. Grillo also is calling for a referendum on whether to keep the euro.

For now, both Berlusconi's PDL and Grillo's 5-Star Movement are trailing the PD by 10-20 percentage points, especially after a primary picked Pier Luigi Bersani - who promised to continue down the path set by Monti - as the party's candidate last week.

For the PD, which now is supported by more than 30 percent of Italian voters according to polls, the sooner the national election the better.

(Additional reporting by Silvia Aloisi and Stephen Jewkes in Milan. Editing by Rosalind Russell)