OSLO/ROME (Reuters) - Prime Minister Mario Monti tried to reassure rattled financial markets on Monday that Italy would not be left adrift following his surprise decision to resign and Silvio Berlusconi's return to frontline politics.
Monti's weekend announcement that he would quit soon because Berlusconi's People of Freedom (PDL) party had withdrawn its support for his technocrat government pushed up Italy's borrowing costs and prompted a stock market sell-off on Monday.
"I understand market reactions. They need not be dramatized," Monti told reporters in Oslo where he attended the award of the Nobel Peace Prize to the European Union and where other EU leaders queued up to praise him.
The former European Commissioner said he was confident the elections would produce a responsible government "which should be in line with the huge efforts already pursued by Italy ... Markets should not fear a decision-making vacuum."
He added: "Let me remind markets that the current government has not left; it's fully in charge and will be so until a new government comes in after the elections."
The campaign for a vote expected in mid-February is likely to be fought over Monti's reform agenda, which Berlusconi, his predecessor as prime minister, said had condemned Italy to recession and forced him reluctantly to run for a fifth term.
European leaders were anxious to stress that any new government must stick to Monti's economic reform agenda.
"Monti was a great prime minister of Italy and I hope that the policies he put in place will continue after the elections," said European Council President Herman Van Rompuy in Oslo.
There were similar comments from policymakers ranging from French President Francois Hollande 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.
Attention is now focused on 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.
"I'm not considering this particular issue at this stage. All my efforts are being devoted to the completion of the remaining time of the current government," he said in Oslo.
Monti has repeatedly warned of the danger posed by the rise of populist, anti-European forces in the region and said he hoped such forces would not dominate the Italian election campaign.
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.
Opinion polls suggest Berlusconi has little chance of re-election, and he has struggled to reassert a previously undisputed domination of rival factions and courtiers in his deeply divided centre-right party.
In contrast, his enemies in the centre-left Democratic Party (PD) under Pier Luigi Bersani hold a strong lead and are likely to form the next government on a broadly pro-European platform, largely in line with Monti's agenda.
Bersani - who hopes that the former European Commissioner will stay on in some capacity, possibly as Italy's president - said on Monday that "precisely because Monti should still be able to be of service to this country, it would be better for him to stay out of the (election) contest".
Berlusconi's strategy appears 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.
After several weeks of calm, markets bridled at the prospect of Berlusconi's return to lead the centre right, just over a year after a financial crisis drove the scandal-plagued billionaire from office to be replaced by Monti's technocrats.
The main measure of investors' confidence, the spread between Italian 10-year government bonds and their German equivalent, widened to 352 basis points on Monday from 325 late on Friday, reflecting worries over a return to the political uncertainty that dogged Italy last year.
Milan's blue-chip share index dropped over 2 percent, with sharper falls in banking stocks, which are seen as most vulnerable to a renewed debt crisis.
Berlusconi's reappearance on the frontline and the prospect of a messy anti-Monti election campaign galvanized attention in Italy and abroad, reawakening memories of the financial and sexual scandals that peppered the media magnate's last government.
Not that such memories have had much chance to slumber. On Monday the prosecutor in Berlusconi's trial on charges of having sex with a juvenile prostitute accused the 76-year-old of delaying tactics after the young woman failed to appear as a witness.
The Roman Catholic Church made outspoken and thinly veiled criticism of the former premier that could influence the PDL's 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 head of the Italian bishops' conference, Angelo Bagnasco, told the Corriere della Sera.
French Finance Minister Pierre Moscovici also weighed in.
"The direction that Italy has been going in for the last year and a half is a solid direction, there is no reason to worry," he told Reuters in an interview.
"Berlusconi is returning to politics, but I'm convinced that he will not return to power," he said.
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 victory 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 Monti's promises on fiscal discipline.
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.
For a factbox on Monti's record see
(Additional reporting by Luke Baker, Vegard Botterli, Lisa Jucca, Silvio Aloisi, Giancarlo Navach, Alessia Pe, Maria Pia Quaglia and Jean-Baptiste Vey; Editing by Barry Moody, David Stamp and Will Waterman)
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