Italian stocks tumble as Berlusconi battle heats up

Former Italian Prime Minister Silvio Berlusconi.
Franco Origlia | Getty Images
Former Italian Prime Minister Silvio Berlusconi.

Silvio Berlusconi may no longer be Italy's prime minister, but his political clout still casts a long shadow over the nation's political scenery - and markets.

Italy's FTSE MIB traded down around two percent on Monday after members of Berlusconi's center-right People of Freedom (PDL) party threatened over the weekend to bring down Prime Minister Enrico Letta's government.

Letta's Democratic Party (PD) responded by saying they wouldn't be "blackmailed" by Berlusconi's party.

The fighting between the two major parties in Italy's ruling coalition centers on whether Berlusconi will be expelled from parliament.

(Read more: Italy Could Be Riskiest of EU Coalition Governments: JPMorgan)

The former Prime Minister was recently convicted for tax fraud and the Italian Senate is set to vote next month on whether he should be expelled from the legislature.

"Berlusconi needs to take note of what led to his conviction, and he has to explain why he would bring down the government at a time of crisis," PD secretary Guglielmo Epifani told the daily newspaper la Repubblica on Monday.

The crisis raised the prospect of more political instability that could delay the country's economic reforms at a time when the Italian economy was showing tentative signs of a recovery.

(Read more: Silvio Berlusconi takes fight for survival to Italy's beaches)

The FTSE MIB rose 6.8 percent in the last month, outperforming both the German DAX and French CAC 40.

Italian banks UniCredit and Intesa Sanpaolo both fell around 4 percent on Monday, as investors worried about their holdings of Italian sovereign bonds.

Shares in Italian broadcaster Mediaset - owned by Berlusconi - fell over 6 percent and were suspended in late morning trade.

David Lea, senior analyst at Control Risks, said that when Berlusconi's PDL brought this issue up a few weeks ago, many thought the debate would go nowhere and the threat would die down. Now, however, it's getting more serious.

"The PDL kind of know that without Berlusconi, they're nothing," Lea said. "So they have to do everything they can to keep him on-board - the pressure might be enough to force the president to pardon him for practicality's sake."

(Read more: Berlusconi won't give in: What it means for Italy)

Lea said trouble is never far away when Berlusconi is in the news. "Things will never be calm and stable while he's around. He's so totemic to the right and such a bad guy in everyone else's eyes that politics and economics can't be normal while he's there."

But Nicholas Spiro, managing director of Spiro Sovereign Strategy, said investors "shouldn't jump the gun here." Instability has been part and parcel of Italian politics since the Second World War, with short-serving coalitions frequently in government.

"It's a serious source of concern but it pales into insignificance in terms of the big issues which are keeping investors awake at night; the debilitating sell-off in the emerging market class being one," Spiro said.

Spiro argued that yields would not experience a long-lasting impact from the crisis unless the government actually fell. Spiro said the government in Rome was incredibly weak, and that while it was hanging by a thread, it could still do so for a year or more.

"Politics has always been very important to the Italian credit story. This is one of the lingering risks that may rear its ugly head in the euro zone come September. Italy is one to watch. But remember, neither of these parties are ready for a snap election so one has to treat all of these words and threats with caution."