BRUSSELS, May 25 (Reuters) - A new government is taking shape in Italy which is worrying the EU and financial markets over Rome's commitment to the euro and the economic rules that membership entails. Here are answers to five key questions:
IS ITALY DITCHING THE EURO?
After an inconclusive March election, the president this week asked political novice Giuseppe Conte to form a government. He was nominated by two anti-establishment, Eurosceptic parties, The League, far-right and strong in the north, and 5-Star, big in the poorer south. But although critical of the effect the single currency has had on the economy, their joint draft programme foresees retaining the euro.
SO WHY ALL THE JITTERS IN FINANCIAL MARKETS?
Because although they say they want to keep the euro, they also want more flexibility to cut taxes, borrow and spend despite Italy already straining at the limits the EU sets on public debt and deficits. An idea to pay some government bills with special new debt sounds to many like recreating the lira. The EU executive and heavyweight partners like Germany and France have lined up to warn Rome not to defy the rules, which they argue are in Italy's interests if it makes other reforms. Earlier talk of writing off loans and moves to appoint a fierce critic of the euro project as finance minister have made lenders question whether Italy will honour its debts. On Friday, Rome was paying six times as much annual interest as Germany to borrow for 10 years -- double the premium it needed a month ago.
IS ITALY "THE NEW GREECE"?
Along with Ireland, Portugal and Cyprus, Greece was bailed out by fellow euro zone governments after its access to private loans effectively dried up as its debts became unsustainable. In 2015, the left-wing government in Athens was nearly bounced out of the euro by German and other northern hawks after rejecting austerity terms demanded in return for loans from governments. In the end, it agreed and now owes other euro zone states some 230 billion euros. The zone's bailout fund has a further 400 billion euros in reserve. But it can do little for Italy, whose economy is 10 times that of Greece and whose 2.4 trillion euros of debt are worth nearly the entire national annual income of France. In other words, Italy is "too big to fail" -- the euro zone simply cannot afford to bail out its third biggest member.
The EU believed a Greek default would destroy faith in its currency, driving up costs for other governments. An Italian default would do that in spades. But a Greek-style bailout is not a option. At the same time, other EU states say Italy's economy, while sluggish, is far stronger than Greece's and has diverse underpinnings giving it many options to revive competitiveness.
BUT WHAT IF ITALY CAN'T PAY, OR WON'T PAY?
The European Commission polices rules under which Italy is supposed to run budget policies that can reduce its debt. It has not managed to do that in recent years but if it started to let debt balloon, the Commission could reprimand it and issue fines. EU officials acknowledge that such measures are limited and that market and domestic political pressure can be more effective. As happened in Greece, the European Central Bank could curb access to euros for Italian banks if it deemed the Italian public debt they hold as a big part of their capital was of dubious value. That would happen if Italy's credit rating fell below investment grade, which would either make Italian bonds no longer eligible as collateral for ECB liquidity, or make such financing much more costly for Italian banks. Similar circumstances forced Greece to impose capital controls in 2015, a first step to creating a difference between euros held in Greece and outside. Unable to borrow in euros or other currencies because investors would demand huge yields to compensate for fears of not being repaid, the Italian state could issue money-like instruments to pay, say, pensions or public salaries. A vicious circle of lost confidence could quickly see Italy effectively out of the euro.
AND SO HOW LIKELY IS THAT?
Italy crashing out of the euro would massively disrupt, at least in the short term, not just the Italian economy but the whole of Europe, giving politicians, businesses and voters at home and abroad a big incentive to avoid it. It would also be a huge political blow to the EU project as a whole, casting doubt on many other plans and Europe's standing in the world -- the reason Germany, France and others paid up to rescue Greece.
Two things stem from that: first, the new Italian government faces a shifting domestic political situation and pressure not to cause havoc -- so a rapid shift from existing policy seems unlikely and it may struggle to survive even without starting on such a radical course; and second, offering some offsetting hope to the new leaders in Rome, the rest of the EU will do all it can to avoid a debacle. Even if a Greek-style bailout seems out of the question, Brussels, Berlin and Paris will spare no effort to cajole, persuade and help Rome stay the euro course. (Reporting by Alastair Macdonald; zmacdonaldrtr Editing by Peter Graff)