By Francesco Canepa
FRANKFURT (Reuters) - A government crisis in Italy is complicating a politically sensitive plan devised by the European Central Bank to support indebted euro zone countries on the bond market before it even starts in earnest.
In an unprecedented effort to cap borrowing costs, the ECB said last month it would buy more of a given state's bonds if its debt yields rose too far in an unwarranted fashion.
The scheme, using the proceeds of the ECB's existing bond holdings as well as a new mechanism to be unveiled next week, was a response to a sudden rise in yields across southern Europe.
The rise was most acute in Italy, largely due to investors pricing in slower economic growth and the impact of higher interest rates on its 2.5-trillion-euro debt pile.
But the latest surge in Italian bond yields and in the borrowing premium it pays over safe-haven Germany has been harder to interpret, as markets respond to fears of a collapse of Mario Draghi's government, whose fate hangs in the balance.
This leaves the ECB in the awkward position of determining which part of the spread widening is "unwarranted" - or giving up buying Italy's bonds altogether.
That decision has legal implications, as intervening in the middle of a government crisis would provide fresh ammunition to those who have accused the ECB, via its market transactions, of breaking the law by getting involved in politics.
Such criticisms - along with lawsuits challenging a long-running ECB asset purchase scheme - have been prominent in Germany.
Bundesbank President Joachim Nagel has this month fleshed out its latest concerns, saying that determining if a risk premium was justified or not was "virtually impossible", and that market prices should be deemed as fair until proven otherwise.
"The spread widening is the result of the market reassessing the fiscal outlook and the prospect for reforms, so before a new government is known it's difficult to say that it's unwarranted," said Dirk Schumacher, an economist at Natixis.
VOLATILE SPREADS
The ECB is buying bonds from Italy, Spain, Portugal and Greece with some of the proceeds it receives from maturing German, French and Dutch debt in a bid to cap spreads between countries' borrowing costs.
It is also working on a new programme to allow it to buy even more bonds from Southern European countries, using newly minted money that could then be offset by draining liquidity via reverse auctions or certificates of deposits.
In both cases, purchases can only be activated if what the ECB terms financial "fragmentation" between different countries is deemed unjustified.