Italy's Minister of Finance Minister Giulio Tremonti looks on during a news conference in Rome July 28, 2011. [Photo/Agencies]

ROME - Italy's divided centre-right government faces a testing week with Economy Minister Giulio Tremonti weakened by a graft scandal just as markets have turned on the euro zone's third largest economy.

Tremonti, the budget hardliner credited with keeping Italy's huge public debt from sliding out of control, has looked more and more exposed, at odds with Prime Minister Silvio Berlusconi and undermined by a corruption probe against a former aide.

As parliament prepares to break for the summer on Friday, the opposition has stepped up calls for the government to resign, urging Tremonti to explain his links with Marco Milanese, a former adviser under investigation over alleged bribery and influence-peddling.

"These are things - and I'm thinking of the relationship with Marco Milanese - which certainly have to be cleared up," Gianfranco Fini, speaker of the lower house and a bitter adversary of Berlusconi told Il Messagero daily on Sunday.

He said Tremonti's position was "exclusively a problem for his own conscience".

The growing uncertainty over Tremonti's position has spread alarm on financial markets already panicked over the euro zone debt crisis, pushing Italy's borrowing costs to record levels last week and triggering a sharp slide in bank shares.

"Tremonti is really seen as an anchor of stability by the markets. In this period of turmoil, he has really been trusted," said Barclays Capital economist Fabio Fois.

Tremonti is not directly linked to the accusations against Milanese but has admitted "mistakes" in paying 1,000 euros in cash a week to rent a flat from his former aide, an arrangement which awakened suspicions the cash payments were to avoid tax.

A sometimes prickly and abrasive figure openly disliked by other ministers and increasingly estranged from Berlusconi, he has denied doing anything illegal and has refused to step down, laughing off market rumours last week that he was about to quit.

But his position has looked weaker than at any time since the government came to power in 2008 and Italian newspapers speculated at the weekend that he may be gone soon, replaced by an outside candidate such as Treasury director general Vittorio Grilli or former European Commissioner Mario Monti.

"Just about no one in the government or in the parliamentary party has made the slightest expression of public solidarity, starting of course with the prime minister," business daily Il Sole 24 Ore said in a front-page editorial.

"There is a crowd of friends, ex-friends and adversaries, standing around him, watching him sink into the quicksand."

 

Austerity

Berlusconi's government, divided and struggling to recover from two heavy recent electoral losses, has faced questions from ratings agencies over its ability to pass the kind of reforms needed to revive Italy's chronically sluggish economy.

Without growth, it will be impossible to cut the debt, and preliminary second quarter GDP data on Friday will be closely watched as worries have grown that even the meagre 1.1 percent growth the government forecasts this year may not be achieved.

But in Tremonti, who pushed a 48 billion euro austerity package through parliament this month to keep Rome on course to bring its budget into balance by 2014, Italy has at least had a finance chief trusted by markets with holding the budget line.

"Italian fiscal policy has been quite successful over recent years in keeping control over the budgets but market sentiment is going to be crucial," said Fois, from Barclay's Capital.

"One of the reasons you've seen bond yields rising is fears over contagion," he said.

Despite having one of the euro zone's heaviest debt burdens at 120 percent of gross domestic product, Italy has largely stood on the sidelines of the crisis thanks to its relatively modest budget deficit and conservative financial system.

But with some 1.6 trillion euros of bonds outstanding and 157 billion euros maturing by the end of 2011, it could trigger a much wider crisis across the euro zone if it were sucked into the kind of turmoil that has hit Greece, Portugal or Ireland.

A closely watched auction on Thursday, in which the Treasury sold 8 billion euros of bonds, saw yields on 10 year BTPs hit 5.77 percent, the highest since February 2000, against an average in 2010 of just over 4 percent.

While a yield level of 7 percent is widely seen as the red line, Bank of Italy deputy director Ignazio Visco said this month a 100 basis point rise would add 0.2 percentage points of GDP to borrowing costs in the first year, rising to 0.4 and 0.5 points in the second and third years.

Such a rise would throw efforts to bring the deficit down completely off track, raising questions over the ability of the euro zone to bring the debt crisis under control.

Already last week, Italian officials indicated that the rise in borrowing costs might mean that Italy does not contribute to the next tranche of a bailout for Greece.  

That would pile further pressure on the euro zone's top economies Germany and France to pick up the slack and would undermine one of the euro zone's main crisis resolution tools.