Q&A: Investors are wary of the outcome of the Italian elections and the effect on the eurozone

Investors are keeping a wary eye on Italy as the country heads to the polls Sunday and Monday to elect a new parliament. They fear that a new government and prime minister could weaken or scrap the economic reforms and budget cuts begun by outgoing Prime Minister Mario Monti during his 15 months in office and hurt Italy's chances of recovering from a decade of low growth.

While the markets are unlikely to punish Italy as they did in 2011-12, they will want to make sure a new government doesn't mean a return to Italy's bad old days.

Here are some questions and answers about this weekend's elections matter for Italy and the rest of Europe.

Q: Why all the worry?

A: Italy's economy — the third-largest among the 17 European Union countries that use the euro — has only grown less than a half percent a year on average for a decade. That is compared to 1.25 percent in other rich Western countries. Faster growth is needed to shrink Italy's mounting debt burden, which already equals 127 percent of its annual gross domestic product.

Because of its size, Italy's problems can dent market confidence in the whole eurozone. Doubts about Italy's ability to manage its debt caused markets to question whether the euro could survive in 2011-12.

Q: What's wrong with its economy?

Before it joined the euro in 1999, the country used to give its economy a boost by to devaluing its old currency, the lire — a trick that used to make its exports cheaper.

Devaluation helped mask underlying problems such as labor rules that favor vested interests such as unions and established workers, which kill off job prospects for younger people; a high business tax burden and heavy cost to businesses from expensive public utilities and red tape.

Italy "remains in dire need of structural reforms to boost competitiveness and improve trend growth," wrote economists Norbert Aul and James Ashley at RBC Capital Markets. They noted that the only economies that have grown more slowly in the past 12 years are Zimbabwe, San Marino, and Portugal.

A growing economy would increase government revenue from business and income taxes and the country's debt.

Q: Where does Monti come into all this?

A: Italy's political parties installed Monti, a former EU commissioner and academic, as prime minister to lead a temporary crisis government of financial experts in November, 2011. His predecessor, Silvio Berlusconi, resigned after high borrowing costs, fed by fears Italy would not pay its debts, threatened the country with financial ruin and rattled confidence in the eurozone.

Monti set about easing some of Italy's anti-business practices, such as labor laws that made it extremely difficult to fire longtime workers. He reduced the budget deficit with the help of an unpopular tax on homes.

Italy's deficit is down to around 3 percent of gross domestic output for last year — not great, but it complies with the official limit for eurozone members.

However, in January, Monti resigned as Prime Minister after Berlusconi's party withdrew its support and criticized his cutbacks - hence the new elections.

Q: So now the elections are under way, what are investors afraid of?

A: Italy's Byzantine election laws could mean many different outcomes. The worst result would be no party or coalition being able to form a government, leading to new elections.

Researcher Vincenzo Scarpetta at the Open Europe think tank says the probability of this is "very low" but that re-run elections could mean "potentially, huge market pressure, which Italy can hardly afford." This pressure would come in the form of rising interest rates on government debt.

Another possibility could be a parliament so divided that it can't govern effectively, or a shaky coalition of parties with clashing agendas — meaning that any policies would be the result of endless compromise and back-room deals. A badly split parliament "would surely affect investors' confidence as Italy's political future would remain unclear," said Aul and Ashley.

The return of a government led by Berlusconi's center-right coalition — regarded as unlikely — could also dismay markets given his call to repeal Monti's home tax and the lack of confidence markets showed in him in 2011.

Q: What do markets want to see?

A: Analysts say investors seem to be anticipating that the center-left Democratic Party, led by Pier Luigi Bersani will win. Bersani opposes budget austerity but is regarded as not totally against all efforts to improve conditions for business. Markets would like it best if he wins but still needs the seats won by small parties led by Monti to govern. That would mean the government might continue with some of the reforms.

Q: So should we expect market chaos and the eurozone crisis to erupt again?

A: Not right away, no. Italian law requires extensive consultation, so it could take weeks to tell who is in charge. In 2008, it took 24 days for Berlusconi to be sworn in despite a landslide win.

However, an anti-reform result could mean Italy's borrowing costs could rise in the days and weeks following the election.

That would be a sure sign that bond investors are more skeptical of the country's long-term ability to pay.

But it's considered unlikely that the yields would immediately rise to the record levels of last year that threatened to push Italy to default. That is thanks to the European Central Bank, which has done much to calm fears that a country will be unable to pay its debts. In September, the ECB offered to buy unlimited amounts of bonds issued by indebted countries, if they agree to reforms and to cut their deficits. No one has used the program yet but its mere existence has lowered Italy's borrowing costs.

Nonetheless, a new Italian government that rejects reform "will lead to more uncertainty, higher yields and a gradual process toward the situation we had last year," says Carsten Brzeski, an analyst at ING in Brussels.

The big problem is the long-term absence of growth rather than what the markets do next week.

Economists Aul and Ashley warn: "Whichever party ends up in power... needs to focus upon Italy's economic frailties as a matter of priority."