Italian borrowing costs soared and share prices tumbled on Monday as the markets took fright at Prime Minister Mario Monti's announcement that he will step down early.
Monti, a well-known economist who is respected among financial investors, said on Saturday he would quit once the budget for 2013 is approved, after losing the support of Silvio Berlusconi's centre-right PDL, the largest party in parliament.
Coupled with Berlusconi's announcement that he would run for office again, Monti's news sparked fears Italy could stray from the path of economic reform after general elections now expected to be taking place in February.
"The main concern is the prospect of a return of economic instability," said Davide Pasquali, chairman of investment fund Pharus Sicav.
Polls suggest a stable pro-European government would replace Monti's technocrat administration. But the weekend's news was enough to put Italy back into the spotlight of the euro zone crisis alongside Spain, whose yields also climbed on Monday on the back of the turmoil in Rome.
The premium Italy has to pay to sell 10-year bonds over safer German equivalents leapt 30 basis points to 357, its highest in three weeks albeit still a far cry from the record 574 basis points at the peak of the financial crisis.
"If the spread goes back above 400-450 basis points, Italian banks will find it very difficult to access the wholesale market," said a senior Italian economist.
Italy will have completed its refinancing for the year after this week's debt auctions, which remain on schedule despite Monti's move, a source close to the treasury told Reuters.
BANKS HIT HARD
Italian shares dived more than 3 percent, with banks hit hard due to their hefty domestic government bond holdings. <.FTMIB>
Banca del Monte dei Paschi di Siena , the weakest of Italy's five systemic banks, fell more than 6 percent and was suspended at one point due to excess volatility.
The bank needs parliament's green light for nearly 4 billion euros (3.22 billion pounds) of state aid. Its last chance to get the aid is if this is approved together with the budget law, the final parliament act Monti is ready to oversee before quitting.
Betting against Italy while the government is a lame duck made it an easy game for speculators and more turmoil is to be expected, bankers said.
The picture could be further complicated if international ratings agencies that have already placed Italy under review for a possible downgrade were to pull the trigger.
Still, analysts and senior Italian bankers say market jitters would abate if it becomes clear the Italians will elect a pro-Europe government, as polls currently indicate.
"At present, the most probable outcome remains that of a centre-left coalition government, with Monti involved in some institutional role. This would broadly see a continuation of policies introduced by the Monti government," said Francesco Garzarelli, an analyst at Goldman Sachs.
Monti, called in a year ago as a technocrat prime minister to replace Berlusconi and guide Italy out of an acute financial crisis, has not yet decided whether he will continue to play a political role.
European Council President Herman Van Rompuy said on Monday that whoever replaces him must keep pressing ahead with similar reforms and budget consolidation efforts to restore confidence and stability both in Italy and the euro zone.
"There is a lot of noise right now, and it will continue for a few days. But in practice not much has changed and we are heading towards a centre-left, pro-Europe government," said a top Italian banker. ($1 = 0.7735 euros)
(Writing by Lisa Jucca; Additional reporting by Francesca Landini; Editing by Hugh Lawson)