Italian borrowing costs soared and share prices tumbled today as the markets took fright at prime minister Mario Monti's announcement that he will step down early.
Mr Monti said on Saturday he would quit once the budget for 2013 was approved, after losing the support of former prime minister Silvio Berlusconi's centre-right PDL, the largest party in parliament.
Coupled with Mr Berlusconi's announcement that he would run for office again, Mr 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 Mr 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 today 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.
Italy will have completed its refinancing for the year after this week's debt auctions, which remain on schedule despite Mr Monti's move, a source close to the treasury told Reuters.
Italian shares dived more than 3 per cent, with banks hit hard due to their hefty domestic government bond holdings.
Banca del Monte dei Paschi di Siena, the weakest of Italy's five systemic banks, fell more than 6 per cent and was suspended at one point due to excess volatility.
The bank needs parliament's green light for nearly €4 billion of state aid. Its last chance to get the aid is if this is approved together with the budget law, the final parliament act Mr 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.
Mr Monti, called in a year ago as a technocrat prime minister to replace Mr 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 today 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.
Reuters