Italy: Too Big to Fail, Too Big to Save?

Italy's economic problems took center stage Monday as its government, led by increasingly threatened Prime Minister Silvio Berlusconi, faced yet another key vote.

Vincenzo Pinto | AFP | Getty Images Italian Prime Minister Silvio Berlusconi

The health of the euro zone's third-largest economy has come into focus despite Berlusconi accepting IMF monitoring and surviving several confidence votes in recent months.

Italy's size makes the potential consequences if it were to fail more wide-ranging than the much smaller Greece.

"Italy has much more systemic implications," Thanos Vamvakidis, Head of European G10 FX Strategy, BofA Merrill Lynch Global Research, told CNBC Monday.

"It's too big to fail, too big to save."

The problems facing Italy include the euro zone's second-highest debt-to-GDP ratio, and the lack of a credible alternative to Berlusconi's government.

Italian MPs will vote Tuesday on the country's public finances, with a number of rebel MPs from Berlusconi's party threatening to vote against the government in protest at the way it has managed the country's finances.

Yields on Italian 10-year bonds surged last week, and are now dangerously close to the unsustainable 7 percent level. Other euro zone countries such as Portugal and Ireland had to seek bailouts after their yields rose to over 7 percent.

"The markets don't believe Berlusconi," said Vamvakadis.

"When other countries were faced with pressure, they introduced more reforms. In Italy, you don't have a clear structural reform agenda."

Yields on short-term 2-year Italian bonds have also been surging.

"When yields on short-term debt start increasing at a faster pace than long-term debt you have a problem on your hands because it signals that investors have no faith that you can pay back the money you owe," Kathleen Brooks, research director UK EMEA at Forex.com, wrote in a research note. "It looks like Italy has gone for the bailout-lite option, but will it need to go the whole hog? The bond markets certainly think so, and it could happen sooner than we think."

There were also signals that the European Central Bank (ECB) will not continue its bond-buying program, which has helped keep bond yields at sustainable levels since the summer. Yves Mersch, a member of the central bank's Governing Council, warned in an interview with Italian newspaper La Stampa on Sunday that it could stop buying Italian bonds if Italy fails to take appropriate action over its debt.

"They are trying to put maximum pressure on the Italian government to deliver," said Vamvakidis.

"It's a risky move but I think it's the right decision at this point."

"It is probably only the ECB’s SMP (Securities Markets Program) program that has prevented Italian bond yields from climbing to even more punitive levels," analysts at Deutsche Bank wrote in a research note. "So it will be a test of ECB firepower and will to keep Italian bond yields under control while the Greek story boils over."

Christine Lagarde, Managing Director of the International Monetary Fund (IMF), issued a strong warning to the Italian government over the weekend.

"We will go quarterly [to Italy]," she told reporters.

"We will check that what Italy has promised Italy is delivering. And if it is not delivering I will say so."