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Italy in crisis as Letta struggles to secure budget

New Italian Prime Minister Enrico Letta
Getty Images
New Italian Prime Minister Enrico Letta

Italy's coalition government appeared increasingly fragile Friday after prime minister Enrico Letta struggled to secure a package of spending and tax measures designed to help keep a lid on the country's deficit.

According to Reuters, Letta met ministers late Friday to avoid a hike in the country's sales tax and secure approval for additional budget measures. But officials told Reuters that no deal had yet been reached.

Earlier Friday, Letta flew back from a trip to New York on Friday to meet with the country's president and try to resolve a political crisis that is threatening to tear the government apart.

The two were set to meet to discuss a tense political situation after Silvio Berlusconi's center-right People of Freedom (PDL) party issued a threat on Wednesday to pull out of the country's fragile coalition government.

The PDL have said they will resign if their leader was expelled from parliament following a conviction for tax fraud. Former Prime Minister Berlusconi was last month sentenced to four years in prison, reduced to a year under house arrest or community service. The Italian Senate votes on the matter October 4.

(Read More: Italy crisis increases as president pulls out of meeting)

"(It's) crunch time for Berlusconi," Wolf Piccoli, managing director at Teneo Intelligence told CNBC Friday. "He knows over the next three or four weeks that it is basically the last phase of his political battle. It's brinkmanship at its best. Posturing, whatever you want to call it."

Letta, speaking before he left from New York, said that the situation was a "humiliation" for Italy as the government tries to decide on urgently needed deficit-cutting measures on Friday.

Italy's president, Giorgio Napolitano, had to cancel his attendance at a political conference on Thursday, according to media reports, due to a "disturbing" political development that required his attention.

The news weighed heavily on Italian stocks on Thursday, which sank nearly 2 percent in afternoon trade. On Friday, shares were moderately lower and the yield on Italian benchmark 10-year debt rose 0.08 percentage points - reaching a 3-month high - helped along by a bond auction.

(Read more: Is the net closing in on 'Houdini' Berlusconi?)

Investors remained cautious on developments in the country. Italy is the euro zone's third-largest economy and, although its budget deficit is within European Union limits of 3 percent, political instability has threatened to disrupt not only the country's government but its economy too.

Later Friday, the International Monetary Fund (IMF) warned that Italy faced a "gradually widening competitiveness gap" between it and other leading members of the 17-country euro zone.

In its regular assessment of the country's economy, the IMF said that Italy's problems stem from "its stagnant productivity, difficult business environment, and leveraged public sector. The inefficient judicial system has also been linked to the high cost of doing business, low inward foreign direct investment, as well as the small size of firms and capital markets."

Virginie Maisonneuve, head of global and international equities at Schroders, said she was worried on the outlook for Italy when compared to fellow euro zone struggler Spain. Competitiveness, inward investment and exports have all improved for Spain, leaving Italy lagging behind, she said.

(Read more: Italy seeks to reassure as crisis looms)

"I think the momentum has been lost in Italy," she said, adding there are several reasons why Europe could be thrown back into financial valiantly and Italy is definitely one of them.

Piccolo said that any political crisis in Italy that results in an election, especially when the electoral system still lacks the ability to provide a stable government, would be a disaster.

"Obviously there is the risk of an accident, the situation is very volatile," he said, but thought the possibility of another election was slim.

The euro, however, has been left relatively untouched by the news coming out of Italy. Last year, when fears were circling that Italy and Spain could soon need a bailout – one that the euro zone could not afford – the euro fell sharply against the dollar while the yield on 10-year Italian bonds spiraled higher.

Chris Walker, an FX strategist at Barclays told CNBC Friday that promises by the European Central Bank (ECB) to buy up unlimited amounts of a struggling country's bonds mean that political crises in countries like Italy no longer mean volatility in the currency markets.

"We've had this commitment from the ECB last July, it means that what is ultimately a negative risk event for Italy isn't necessarily a negative event for the euro," he said.

By CNBC.com's Matt Clinch. Follow him on Twitter @mattclinch81

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