Yields on Italian bonds shot to crisis levels above 7 percent on Wednesday and European stocks sank as a short-lived rally on Italian Prime Minister Silvio Berlusconi's pledge to resign evaporated.
A 7 percent yield is widely deemed as unsustainable and has previously led to bailouts and talk of default in smaller euro zone economies. The euro sank 1 percent against both the dollar and yen.
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Investors initially greeted the likely exit of Berlusconi as leader of the euro zone's third-largest economy positively, but then began fretting about who his successor might be and how long political instability would last.
"There is no guarantee (Berlusconi's) successor will be able to do a better job. Just keep your eyes on the Italian yield for now," said Christian Jimenez, fund manager and president of Diamant Bleu Gestion.
Berlusconi said late on Tuesday that he would step down after parliament passes budget reforms. His often controversial presence at the top has been viewed by many in the markets as a block to fiscal reform.
Investors were also keeping an eye on Greece, which was struggling to create a consensus government under a new, yet-to-be-agreed prime minister.
World stocks as measured by MSCI were down a third of a percent, while in Europe the FTSEurofirst 300 lost 1.3 percent.
Earlier, in Japan, the Nikkei average closed up nearly 1.2 percent on optimism about the Berlusconi departure.
Shares of camera maker Olympus , however, fell 20 percent. On Tuesday, the scandal-hit firm said for the first time that contentious acquisitions helped it cover losses on securities investments dating back to the 1980s.
Berlusconi's pledge to go did nothing to ease the pressure on his country's debt.
"The mere fact that Italian 10-year bond yields have hit the all important 7 percent level shows that the crisis will not end simply with Berlusconi's excruciatingly slow demise," said Joshua Raymond, chief market strategist at City Index.
Yield's on 10-year Italian bonds were slightly above 7 percent as were two-year bonds.
In fact, the curve measuring the yield inverted for the first time in the euro era -- a clear signal of rising concern among investors that they may not get their money back.
Core German debt yields fell to less than 1.75 percent on 10-year paper in a rush to relative safety.
The euro, beset by the region's two-year debt crisis, fell around 1 percent to $1.370 , down from $1.3773 late in New York and well off a 2-month high of $1.4248 hit on Oct. 27.