By Gavin Jones
ROME (Reuters) - Italy's center left picks its leader for next year's election on Sunday in a primary where supporters will choose between a sharp young modernizer and a veteran political operator as candidates to take over from Prime Minister Mario Monti.
The run-off contest pits Florence Mayor Matteo Renzi, 37, who presents himself as a dynamic candidate for change, against Pier Luigi Bersani, 61, the dour, experienced leader of the Democratic Party (PD) which dominates on the Italian left.
Bersani is strong favorite, having won 44.9 percent of the vote in a first round on November 18, compared with 35.5 percent for Renzi, and is now in pole position to become prime minister, given the strong lead in opinion polls enjoyed by the PD.
As Monti's term in office draws to a close, with markets much calmer than they were when he came to office a year ago at the height of the financial crisis, attention has increasingly turned to what comes after an election expected in March.
Memories of last year's financial crisis are still fresh. It forced out Silvio Berlusconi's scandal-plagued government and brought in former European Commissioner Monti who has impressed with his market-friendly austerity policies.
"I don't expect any market reaction to the primary but it still matters a lot for Italy's political future and that is going to affect markets as the election nears," said Riccardo Barbieri, chief European Economist at Mizuho International.
Analysts said the fresh-faced Renzi would be considered most likely to maintain the reform momentum of Monti's government but markets would still not be spooked by Bersani, who is considered a responsible if uninspired leader.
Both candidates have pledged to continue the budget discipline championed by Monti, while putting more emphasis on economic growth and easing burdens on workers and pensioners.
"With regard to Monti, I think we all feel we have to go a little beyond this experience without renouncing discipline or credibility ... but also striving for a bit more fairness and more jobs," Bersani said in a TV debate with Renzi on Wednesday.
While Bersani has been a loyal supporter of Monti in parliament, markets retain some wariness of his alliance with a far left party called Left, Ecology and Freedom (SEL) that analysts say could be a recipe for instability.
Gianluca Verzelli, vice-director of Banca Akros, a private bank, said there was unlikely to be any strong immediate reaction to the primary but there was a natural tendency in the markets to favor Renzi and his promise of reform.
"Markets generally look positively on more moderate positions and generational change," he said.
In the meantime, Monti remains the darling of investors, many of whom continue to believe that he will end up carrying on as prime minister despite the insistence of the main parties they would not support him for a second term.
He has said he would come back if the election does not provide a clear winner and another role for him is possible as President of the Republic and guarantor that reforms agreed with Italy's European partners continue.
Faith in Monti and, even more importantly, the European Central Bank's promise to protect the bonds of countries willing to reform has helped Italy. At an auction on Wednesday, 10-year borrowing costs fell to their lowest level in two years, with the Treasury paying a yield of 4.45 percent, compared with more than 7 percent at the height of last year's crisis.
"I think the general view among investors is that, if push comes to shove, Monti will always be there to carry on as a backstop," said Citigroup economist Gilles Menuet.
"What would be really negative for Italy's yields is if the outcome of the election is messy and at the same time it becomes clear that Monti is not coming back."
For the moment, the PD's primary has introduced a measure of stability. Even opponents have praised it as a valuable exercise in democracy and a response to the diatribes of the comic Beppe Grillo and his anti-establishment 5-Star Movement.
It has certainly left the party better placed that its center-right rivals, who have been brought to the brink of nervous breakdown by former prime minister Silvio Berlusconi's constant changes of mind over whether to run or not.
For the immediate future, the key issue to be decided is what voting system will be used in next year's election and whether it will allow a stable government to be formed.
Parties have been negotiating for a year to reform the widely criticized current law, which allows party bosses to handpick candidates and entails a different system for allocating seats in the two houses of parliament.
There is no agreement on what to replace it with, and no certainty that whatever compromise is reached will permit the formation of a majority capable of lasting a full five years in the shifting sands of Italian party politics.
For Deutsche Bank economist Marco Stringa, that alone is enough to guard against any complacency and he warned that more surprises remain possible before a new government takes office.
"Uncertainty and potentially high volatility are likely to characterize the journey towards the election and possibly the formation of the new government," he said.
(Additional reporting by Giselda Vagnoni)
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