Portugal's Prime Minister Pedro Passos Coelho said he was confident of overcoming the political problems and would not resign after the country's stock market tumbled 5.2 percent on Wednesday - its biggest fall since 2011 - and bond yields spiked.
In reply to a question from CNBC, he said enormous progress had been made on structural reforms and cutting the deficit. His comments at a press conference in Berlin came after the country was thrown into a political crisis on Tuesday with the resignation of Portugal's Foreign Minister Paulo Portas. Portas, who is the leader of the CDS-PP, the ruling coalition's junior partner, was the second minister to resign from the government in 24 hours.
Yields on Portugal's 10-year government bonds rose to 8 percent, before falling back to 7.469 at the close on Wednesday. That was sharply higher from 6.539 percent at market close on Tuesday. Bank stocks traded sharply lower, with Banco Espirito tumbling over 10 percent, Banco BPI falling 8 percent and Banco Comercial Portugues seeing a fall over 12 percent.
According to media reports on Wednesday, at least two other government ministers from the CDS-PP were also ready to resign.
The news caused concern throughout Europe's political institutions. The President of the European Commission, Jose Manuel Barroso, also a former prime minister of Portugal, said the market reaction showed "the obvious risk" that the financial credibility recently built up by Portugal could be jeopardized by the political instability.
"If this happens it would be especially damaging for the Portuguese people, particularly as there were already preliminary signs of economic recovery," he said in a statement on Wednesday.
"This delicate situation requires a great sense of responsibility from all political forces and leaders. The situation should be clarified as soon as possible," he added.
The president of the eurogroup of finance ministers, Jeroen Dijsselbloem, said that the political situation in Portugal was "precarious" and that the government needed to take responsibility, Reuters reported on Wednesday.
Djisselbloem said he was confident the country was committed to its bailout. Dow Jones reported a senior euro zone official as saying that the next review of Portugal's bailout program would be difficult if early elections were announced.
"We see early elections as the most likely outcome at this stage," Barclays economists Antonio Garcia Pascual and Fabio Fois said on Wednesday.
"The market impact of the political crisis is likely to be very significant for Portugal," the economists added. "We think the decision of Portas to step down is likely to trigger a sell-off in the Portuguese bond markets. However, we do not anticipate the decision being a critical event for the rest of the euro area."
in a sign that investors were jittery, however, the FTSEurofirst 300 Index dropped 1.47 percent in early trade on Wednesday. Spain's IBEX 35 and Italy's FTSEMIB slipped by over 2 and 3 percent respectively on Wednesday morning.
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If the CDS-PP pulls out from the government, Prime Minister Pedro Passos Coelho's government would be in the minority in parliament. Passos Coelho said on Tuesday he would not accept Portas' resignation and would talk to his coalition partner. He also said he would not step down in order to ensure political stability.
Don't Panic
Barclays' economists said markets shouldn't panic yet about a potential change of government. According to them, a fresh election wouldn't necessarily bring about a radical departure from the current bailout program because the opposition Socialists had also signed a memorandum of understanding with the "troika" of international lenders in 2011.
"While such an outcome might steer the country toward more pro-growth policies and a further relaxation of fiscal targets, we do not believe it would represent a radical change in the course of the 'troika' program," they said.
Leading Economist, Nouriel Roubini was also fairly calm about the future of the nation's bailout program on twitter on Wednesday.
Portugal has so far achieved about two-thirds of the more than 10 percentage points of GDP of fiscal consolidation required by lenders, the economists stated.
But European markets are already jittery after international lenders gave Greece three days to reassure Europe and the International Monetary Fund (IMF) that it can deliver on conditions attached to its own bailout, in order to receive its next tranche of aid.
Portugal's Finance Minister Vitor Gaspar, who implemented unpopular austerity measures as part of the 78 billion euro ($101 billion) EU-IMF bailout, stepped down on Monday causing bond yields to immediately spike. But, Bob Parker, Senior advisor to Credit Suisse told CNBC Europe's "Squawk Box" that investors should not compare Greece to Portugal.
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"The bailout is about two thirds of the way through and I would highlight on Portugal their success in privatization program and their success at attracting foreign investment. Yes, we have a political hiccup in Portugal but my central case would be that the government holds and that the program is on track. With Greece it's a different story," Parker said on Wednesday.
Sell-Off 'Overdone'
The head of developed market rates at ING Wholesale Banking said the rise in borrowing costs for Portugal was an exaggerated market reaction.
"I think it's a bit overdone," Padhraic Garvey told CNBC Europe's "Squawk Box." "It obviously reflects uncertainty with regards to the political dimension in Portugal but there's been a new finance minister instigated there which is a positive thing given that she's ensuring that the austerity theme that we've seen over the last couple of years [continues]."
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"If I look at how Portugal prices up…it looks to be quite cheap, there's a lot of bad news priced and consequently any stability should be met by some outperformance."
Barclays' economists Pascual and Fois said the Portuguese crisis was less significant for the rest of the euro zone.
"Even if the 'troika' program stalls and there are delays in upcoming disbursements, there are no immediate large cash needs for the Portuguese Treasury, which has sufficient liquidity to meet the large bond payments coming due in September 2013."
- By CNBC's Holly Ellyatt, follow her on Twitter @HollyEllyatt