Italy's central bank chief warned on Tuesday that the state was "only ever a few short steps" from losing investors' trust as markets dumped stocks and bonds, fearing repeat elections will become a de facto referendum on the country's euro membership.
Prime minister-designate Carlo Cottarelli is set to unveil his cabinet on Tuesday, as tensions between the country's president and the two political parties he sidelined flared.
Cottarelli, a former International Monetary Fund official who President Sergio Mattarella chose on Monday to head a stop-gap government leading to early elections, was due to meet the head of state in the afternoon.
The anti-establishment 5-Star Movement and the far-right League, the biggest winners from inconclusive elections in March, abandoned plans to form a coalition government at the weekend after Mattarella vetoed their choice for economy minister, an 81-year-old who has argued for Italy to leave the euro.
Investors believe that Cottarelli will fail to muster support to pass a budget, leading to repeat elections in the autumn when the two euroskeptic parties could return with even larger representation in parliament.
These worries sent Italian stocks to their lowest level since July 2017, dragged down by a heavy selloff in financial stocks. The spread between Italy's 10-year bund and its German equivalent grew further to touch more than 270 basis points from Monday's 235 close, its highest since September, 2013.
The continuing uncertainty in the euro zone's third biggest economy also helped the euro tumble to fresh multi-month lows. Investors had already worried about the proposed coalition's ambitious spending program for a country which already has the third highest public debt in the world - plans that were likely to bring it into conflict with the European Union.
Bank of Italy chief Ignazio Visco said any move to weaken the country's public finances could undermine confidence and years of valuable reforms.
Italy's high debt as a proportion of its annual economic output could expose it to dangerous crises of confidence, he told the central bank's annual meeting.
The number of investors expecting the euro zone to lose at least one member state in the coming months has increased due to the crisis in Italy, a survey showed on Tuesday.
The Frankfurt-based Sentix research group said its monthly "euro break-up" index, based on a survey of around 1,000 institutional and retail investors, more than doubled to 13 percent from 6.3 percent in April.
"The turmoil over the Italian government formation, in which the euro-critical parties League and 5-Star want to form an alliance, has alarmed the bond markets," Sentix researcher Manfred Huebner said.
Simple man, complicated job
Cottarelli, whose simplicity startled reporters on Monday when he arrived at the presidential palace by taxi carrying a backpack and pulling his trolley bag, was preparing a slimed-down cabinet of experts with no direct links to political parties to steer the country to elections.
When he accepted the mandate from Mattarella on Monday, Cottarelli vowed that he and his cabinet would step aside after their job is done and not seek political office in the next elections.
Both parties planning the failed coalition were infuriated by Mattarella's veto, accusing him of violating democratic principles.
The 5-Star leader, Luigi Di Maio, called on parliament to impeach Mattarella, which would be unprecedented in Italy's post-World War Two history.
The 5-Star is planning big street protests against the president on Saturday to coincide with Italy's Feast of the Republic, which is usually a time of unity marking the end of the monarchy after the war.
5-Star members took to the streets holding anti-Mattarella placards such as "Sovereignty Belongs to the People", while the president's supporters went on Twitter with the hashtag "I stand with Mattarella."
Even foreign leaders jumped into the fray. French President Emmanuel Macron defended Mattarella's courage and "great spirit of responsibility" and German Chancellor Angela Merkel issued a veiled warning to Italian parties that any discussions on economic policy would have to be within the rules governing the euro zone.
When he names his ministers later on Tuesday, Cottarelli, who served as a cost-cutting tsar to a previous government, is expected to again reassure investors on the Italian economy.
On Monday, when he accepted the mandate from Mattarella, Cottarelli said the country's economy was "still growing and the public accounts remain under control."