* Italy’s borrowing costs rise, stocks drop
* Calls grow for Monti to stay in politics
* Spain worried about possible spillover
By James Mackenzie
ROME, Dec 10 (Reuters) - European partners urged the next Italian government on Monday to stick to Prime Minister Mario Monti’s reform agenda, after his decision to resign early and Silvio Berlusconi’s return to frontline politics rattled financial markets.
Monti’s surprise weekend announcement that he would quit because Berlusconi’s People of Freedom (PDL) party had withdrawn its support for his technocrat government pushed up Italy’s borrowing costs and prompted a stock market sell-off.
The campaign for an election expected in 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.
By contrast European politicians and officials warned that Monti’s policies must continue to prevent a return of the crisis which brought him to power a year ago, when he was charged with rescuing the euro zone’s third biggest economy from the threat of 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 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.
With Rome’s European allies doing little to conceal dismay at the thought of Berlusconi’s return - on a day when his trial on sex charges was also back in the headlines - the billionaire former premier called the EU sniping at him an insult to Italy.
Spanish Economy Minister Luis de Guindos warned that instability there 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.
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.”
He has repeatedly warned of the danger posed by the rise of populist, anti-European forces in the region.
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 his previously undisputed domination of rival factions and courtiers in his deeply divided centre-right party.
The centre-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.
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 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.
“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.
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.
Berlusconi’s reappearance on the frontline and the prospect of a messy anti-Monti election campaign galvanised attention in Italy and abroad, reawakening memories of the financial and sexual scandals that plagued the media magnate’s last government.
Rubbing in the point, 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.
A barrage of comment from European leaders underlined the concern about Berlusconi’s return and the Roman Catholic Church made outspoken and thinly veiled criticism of the former premier that may 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 influential head of the Italian bishop’s conference, Angelo Bagnasco, told the Corriere della Sera.
On Monday night, Belusconi issued a terse statement rejecting the negative comments from foreign politicians and media as an offensive interference in domestic affairs.
He said he had always been a “convinced supporter of Europe” and that the comments were “offensive not so much to me personally but to the free choice of the Italians.”
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 centre-left primary election last month.
A no-frills former communist who is close to Italy’s trade 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.