FRANKFURT – A dramatic anti-austerity vote leaves Italy lying outside the fortress the European Central Bank constructed around the euro zone last year and vulnerable to a market attack.
This week's election leaves slim prospects for a durable, reform-minded government in Rome and exposes a flaw in the bond-buying defense plan the ECB put together last September - a weakness that could see the euro zone crisis roar back to life.
After vowing to do "whatever it takes" to save the euro, the ECB's Italian chief Mario Draghi launched a plan - dubbed Outright Monetary Transactions (OMT) - in September which promised potentially unlimited buying of a struggling country's bonds.
Market pressure on the euro zone's high debtors has subsided ever since, to the extent that even the most cautious policymakers have declared the worst to be over.
The catch is Draghi is ready to do whatever it takes "within our mandate". To satisfy this caveat, the scheme requires a country whose bonds the ECB buys to sign up to a European aid program with debt-cutting conditions attached.
But Italians overwhelmingly rejected Prime Minister Mario Monti's austerity policies in a February 24-25 election that gave no party a parliamentary majority and threatens prolonged political instability in the euro zone's third largest economy.
Markets are unnerved. Italian borrowing costs have risen sharply and jitters have spread to Spain. But fear could turn to greed if investors sense Italy is unprotected.
The ECB, which has yet to activate the OMT, is sticking to its principles and refusing to become fixated by short-term fluctuations of sovereign bond yields.
"If yields go up because of political events, there is not much the ECB can do, that's not related to monetary policy whatsoever," ECB Executive Board member Benoit Coeure said at a Reuters summit on the euro zone's future this week.
When Draghi began forming the OMT plan last July, yields on Italian benchmark bonds were well above 6 percent and heading for 7. Now they are trading around 4.7 percent after flirting with 5 percent just after the inconclusive election.
Sources close to the ECB are conscious of the risk of contagion from Italy to Spain, but insist it will not intervene to help Italy if it does not have a credible government capable of the reforms required for support in the debt market.
SPAIN VULNERABLE TOO
In his first public comments since the election in his homeland, Draghi stressed in a speech in Munich on Wednesday that the ECB's mandate only stretches so far. The subtext was clear: Italy will have to front up and reform.
"We do not act to help governments. We act to help maintain the flow of credit to real firms and households," Draghi said. "Governments need to address the structural problems in their economies."
Germany is aware of the risks of inaction.
Finance Minister Wolfgang Schaeuble told Reuters on Wednesday that Italy's inconclusive election had raised the risk of market turmoil spreading to other euro countries and urged Italian politicians to form a stable government quickly.
A Reuters poll of economists found 44 of 55 thought Italy's turmoil made it more likely the ECB would deploy its bond-buying artillery but with Spain - caught up in Italy's backwash - the more likely recipient.
Spanish Economy Minister Luis de Guindos told the Reuters euro zone summit Madrid was no closer to seeking bond-buying help than it was before Italy's election. But UBS analysts expect Spain to ask for European aid to allow ECB intervention in the second half of this year.
With Italy showing no appetite for the reforms that are a pre-condition for OMT support, a sustained attack on its sovereign bond market could throw the euro zone back into the depths of crisis and land the ECB with a new policy conundrum.
"I think that could happen," Clemens Fuest, the incoming chief of Germany's ZEW economic institute, told Reuters.
"The OMT program in a way was the creation of a safety net and a step forward, but in another way it was also a step back ... the Achilles' heel was a situation like this where one systemically important country rejects austerity."
Under its previous bond plan, the Securities Markets Programme (SMP), the ECB could intervene without necessarily attaching conditions.
In the event of a market onslaught and no reform commitment from Italy, one option for the ECB now would be to sit back and hope the increase in borrowing costs pushed Rome into action.
"Another option, if things go very bad, would be to just intervene in the market and take the risk that the Italian government will do nothing and wait," said Fuest.
But do that and the Bundesbank, German lawmakers and others would throw their hands up in horror at the ECB ripping up its rule book, potentially undermining the entire safety net.
The ECB has already been caught out once by Italy.
In 2011, the bank bought Italian and Spanish bonds under the SMP only for Italy's then prime minister, Silvio Berlusconi, to go back on reform promises he had made to get the ECB to step in.
That experience led the ECB to attach conditions to the OMT plan. But even if an Italian government did commit to reforms, German lawmakers could veto aid.
Berlusconi's strong showing in this week's election will surely give policymakers pause for thought.
Germany's Bundesbank, the biggest stakeholder in the ECB, would certainly disapprove of bond buying. Even with strict conditions, Bundesbank chief Jens Weidmann regards ECB bond buys as "tantamount to financing governments by printing banknotes".
So the option of sacrificing ECB principles would infuriate the bank's most important constituent and risk a schism at the heart of the euro zone's most credible institution.
Berenberg Bank's Christian Schulz, a former ECB economist, did not expect such a scenario to materialize.
"They will only intervene if a country reforms," he said. "Effectively, Italy has voted away the safety net that was in place before and they don't have a safety net any more."
In other words, Italy is defenseless. No wonder European leaders are crossing their fingers and insisting a strong government in Rome can still result.
(Editing by Mike Peacock)