ROME: Prime Minister Mario Monti is preparing reforms to boost Italy's economy after parliament approved a 33 billion euro austerity plan last month which aims to shore up the country's strained public finances but risks weighing on growth.
The measures, which Monti will present at the end of January, are set to include liberalisations, welfare and labour market reforms, but the government faces tough negotiations with unions, who have warned of social tension this year.
Italy, the euro zone's third largest economy, has been at the centre of the debt crisis since last summer, when its borrowing costs began to approach the levels which forced Ireland, Greece and Portugal to seek an international bailout.
That in turn raised the prospect of an emergency which could tear the single currency apart. While a rescue of the smaller economies may be possible, a bailout of Italy would be too big for the euro zone's current defences to handle.
Monti's technocrat government, appointed in November after former Prime Minister Silvio Berlusconi lost his parliamentary majority, is sticking to the aim of balancing the budget in 2013 by implementing his "Save Italy" austerity plan.
Monti said in December that the country had pulled itself back from the edge of a precipice.
But as Italy faces a recession that will make it even more difficult to rein in public debt, the government is drawing up additional "Grow Italy" measures aimed at making one of the euro zone's most chronically sluggish economies more competitive.
In 2012, the Treasury aims to issue around 450 billion euros in new debt, a challenging target given the high yields investors are still demanding to buy Italian bonds, underlined by a disappointing auction at the end of last month.
Much will also depend on how the wider euro zone crisis plays out and whether a sufficient Europe-wide response, including a possible backstop for Italy if extra support is needed, can be formed in case of a renewed emergency.
Here are some of the risks Monti will face.
MARKETS
Yields on 10 year bonds have come down from record highs of more than 7 percent in November following the approval of Monti's austerity measures.
But they are still hovering just under 7 percent, which is seen as unsustainable given the amount that Italy needs to raise through debt issuance in 2012.
With almost 160 billion euros of bonds needing to be refinanced by the end of April, there are concerns that market confidence may be hit by more shocks, wiping out the gains made in the aftermath of Monti's announcement.
Italy faces its first debt auction test of the year on Jan. 12 when it will offer short-term bills, followed by a separate auction a day later when it sells medium to long term debt.
While Italy could theoretically continue paying yields of around 7 percent for several months more, the system would become increasingly vulnerable to a so-called "buyers' strike" where investors take fright and refuse to buy Italian bonds.
Italian banks, which held just under 209 billion euros of Italian government bonds at the end of October, are also vulnerable to bond market turmoil which could spark a banking crisis.
If Italy did need help, it would have to rely on an outside body such as the IMF, the euro zone bailout fund or the ECB, which has been propping up Italian bonds by buying them on the market since August.
Monti said last month that the euro zone bailout fund needed "significantly greater" resources.
Any call for support would have to overcome objections from Germany, which is resolutely opposed to taxpayer bailouts for other euro zone countries or for pooling liability into commonly issued euro bonds as well as from the ECB, which is reluctant to step up bond purchases.
What to watch for:
-Results of upcoming bond auctions. Italy has so far managed to sell the bonds it has offered. Yields on 10-year paper have come down to under 7 percent from levels of around 7.56 percent in November. The failure of an auction to attract buyers could signal a potentially catastrophic loss of investor confidence.
POLITICAL SUPPORT
Monti has said he intends to remain in office until the next scheduled elections in 2013 but he will need to retain the support of parliament and prevent opposition from unions spilling over into mass street protests.
Italy's three main unions attacked his austerity package for unfairly targeting workers and ordinary pensioners and held a series of strikes in December.
After years of division the three unions appear to have united against Monti's reform plans, and analysts say he must move fast on additional reforms while his popularity is high and the sense of emergency over Italy's debt crisis is acute.
A major battle is taking shape over the future of Italy's labour market, between Monti and union leaders including Susanna Camusso, head of the biggest union CGIL. They are due to meet for negotiations over labour reform in January.
Opinion polls point to broad popular support for Monti but that could evaporate if, as expected, the economy slips into recession this year and more tax hikes, cuts or pension changes are needed to stick to budget targets.
Although unelected, Monti needs the backing of parliament to remain in office and there have been ample signs that Berlusconi's centre-right party in particular could withdraw support if it is not happy with the government.
Berlusconi's former coalition partners in the regional Northern League party have gone into opposition and oppose many of the key elements of Monti's package. Their criticisms could start to weigh more heavily if the crisis worsens.
What to watch for:
-Signs that Berlusconi's PDL party or the unions are losing patience with Monti or if the austerity measures or potential labour market reforms prompt wide public opposition and major strikes.
THE ECONOMY
A chronically stagnant economy which is probably already in recession could torpedo efforts to cut the debt, trapping Italy in a spiral in which growth is choked off by repeated doses of austerity administered to control the budget.
Italy's economy contracted by 0.2 percent in the third quarter from the second due to a slump in domestic demand, and analysts expect the downward trend to continue in subsequent quarters.
The government forecasts economic contraction of 0.4 percent this year and zero growth in 2013 but believes that the measures it has introduced should allow it to hit its target of a balanced budget by 2013.
If, as some private sector economists believe, the recession is more serious, yet more cuts could be needed, potentially undermining support for Monti's government.