Italy faces new elections and economic turmoil, analysts warn

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Italy's political chaos could spell further elections, market uncertainty and economic turmoil, analysts warn.

Italian prime minister Enrico Letta is to go before parliament on Wednesday for a confidence vote after five ministers belonging to Silvio Berlusconi's "People of Liberty" party (PdL) resigned from the cabinet over the weekend. The PdL move has threatened to plunge the fragile coalition government and the euro zone's third-largest economy in chaos.

(Read more: Along comes Italy, to spoil Europe's market calm)

The weekend's events won't surprise many as the coalition government – made up of Berlusconi's center-right and Letta's center-left parties – tensions over reforms have meant that it has long been on the verge of collapse ever since its awkward inception in April. In addition, Berlusconi had already threatened to withdraw his ministers if he is expelled from the Senate for a tax fraud conviction he received in August.

However, the stalemate is likely to further delay the spending and economic reforms that Italy desperately need. Unemployment is at 12 percent and the country has a burgeoning debt pile, the second-highest in the euro zone at 130 percent of GDP (the average is 92 percent in the single currency area), according to the Eurostat data agency.

Although Prime Minister Letta told CNBC last week that he hoped Italy would return to economic growth and achieve 1 percent growth in 2014, the latest political upset is likely to knock economic forecasts and rile investors further, market-watchers warned.

"The European foreign exchange market so far isn't getting itself too over-excited [over this] but at an economic level it's going to be a further delay to the kind of reforms to fiscal policy that are needed in Italy," Kit Juckes, global head of Foreign Exchange Strategy at Societe Generale told CNBC on Monday.

"We're on an unsustainable debt path where the debt-to-GDP ratios of Italy and other countries are going up, up, and inextricably up and this kind of politics absolutely guarantees that there won't be the nominal GDP growth rate that gets above the cost of funding the debt that reverses that."

What to expect from Italy

Although Italy's economy minister, Fabrizio Saccomanni, tried to play down the potential market impact of the latest developments, saying investors have already factored in the country's political instability, the yield on Italy's benchmark 10-year bond started rising last week when Berlusconi's party showed signs of discontent. On Monday, Italy's FTSE MiB index opened down 2.2 percent.

Ahead of a Senate vote this week that could see Berlusconi expelled from political life for his tax fraud conviction, Francesco Giavazzi, Professor of Economics at Bocconi University told CNBC on Monday that the world was witnessing the "last steps of a 20-year long regime led by Silvio Berlusconi."

Likening the meeting today in Rome to the decision of the Fascist party members to oust dictator Benito Mussolini from power in 1943, he predicted there would be "more volatility in the short term but a transition to a more stable democracy in the medium run."

Further disruptions to the business world come this week with the ousting of Intesa San Paolo's chief executive Enrico Cucchaiani from Italy's largest retail bank on Sunday, and rumblings of discontent at Telecom Italia too with reports that CEO Franco Bernabe could exit the company this week.

One senior market analyst said he would not be surprised if Italy's political volatility, which has already impeded economic reforms and tax increases this year, faced a credit rating downgrade.

"Given the predilection for Italian politics to be completely dysfunctional, the likelihood of a ratings downgrade has increased further given last week's warnings that one was imminent, in the face of delays at implementing reforms," Michael Hewson from CMC Markets told CNBC on Monday.

(Read more: Will Rome Listen to Italy's Downgrade 'Wake-Up Call')

Mussolini flashback in Letta vote

"Mr Letta will certainly need some form of divine inspiration to prevent further weakness on the Italian bond market this week as investors fret about the next turn of events in the latest turn in the long drawn out Italian soap opera with the prospect of fresh elections coming ever closer," he added.

After holding crisis talks with the prime minister on Sunday, Italy's President Giorgio Napolitano said he would try to find a way to oversee the formation of a new coalition government without calling elections -- as Berlusconi has demanded.

Aware of the increasing weariness of investors and the Italian public, the 87-year old political veteran who delayed his retirement to help Italy's political scene, said Saturday that Italy needed a parliament that worked, "not that breaks up every now and then."

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

However, not everyone within Berlusconi's party is pleased with his decision to pull his ministers from the coalition and on Monday he is expected to meet disgruntled PdL parlimentarians to discuss what to do next ahead of a confidence vote in Letta's leadership on Wednesday.

All five of the ministers who were reported to have been ordered by Berlusconi to resign on Saturday complied but in statements expressed reservations or disagreement with the decision. The statements have prompted Letta to believe he could win over rebels within the centre-right party.

- By CNBC's Holly Ellyatt, follow her on Twitter @HollyEllyatt

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