Investors shunned Italian government bonds and shares on Monday after Silvio Berlusconi pulled the rug from under Prime Minister Enrico Letta's frail coalition government by ordering five centre-right ministers to quit.
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Berlusconi's decision, which comes as the media tycoon is facing eviction from parliament after a tax fraud conviction, has left the euro zone's third-largest economy without a functioning government.
Italy's political strife may ripple beyond the country's borders, particularly if new elections result. It leaves some investors hoping President Giorgio Napolitano's determination to seek a new, although scant, parliamentary majority may avert elections in the short-term.
"In our view, new elections are still unlikely this year, with the coalition government likely to gain the confidence vote this week," said Alberto Gallo, credit analyst at Royal Bank of Scotland.
"However, the government's ability to pass structural reforms and handle the crisis around Italy's corporates and banks remains in question."
The yields on Italy's 10-year bond, a good indicator of long-term sentiment towards Italy, spiked to 4.73 percent at the opening. They later stood at 4.65 percent, well below a 7.5 percent yield hit when Italy reached the peak of its sovereign debt crisis in 2011.
Shares in Milan's blue-chip FTSE MIB, which had plunged 2.5 percent minutes after opening, were down 1.8 percent, with banking stocks and broadcasting group Mediaset , controlled by Berlusconi, being particularly hit.
The new crisis come as next year's budget law is currently under negotiations. Italy is also in the middle of corporate turmoil that has prompted management shake-ups at its biggest retail bank, Intesa Sanpaolo and telecoms company, Telecom Italia. No.3 bank Monte dei Paschi di Siena is still waiting for a EU green light to badly-needed state aid.
But there are positives.
Economic conditions have much improved since the country's borrowing costs became close to unsustainable in late 2011. Fiscal austerity measures pushed through by the former government of Mario Monti are expected to curb any fiscal slippage. Also, the Treasury has already met 80 percent of its debt funding needs for this year.
"The economic situation is so much better now than it was when Monti took over," said Eric Nielsen, chief economist at UniCredit.
In addition, many investors still take comfort from the European Central Bank's bond-buying backstop.
Letta will go before parliament on Wednesday and hold a confidence vote - a move that will clarify what is left of his parliamentary backing.
The outcome of the vote is uncertain as some of Berlusconi's lawmakers from his centre-right party have shown increasing unease over the shock decision to withdraw government support.
Berlusconi is due to hold a meeting with his party later on Monday.
Letta enjoys a commanding majority in the lower house but would need to win over a couple of dozen senators from Berlusconi's PDL party or opposition parties including the anti-establishment 5-Star Movement to be able to be sure of parliamentary support.
"Markets have grown accustomed to Italy's dysfunctional politics, but there's a sense that things are now spinning out of control," said Nicholas Spiro, who runs specialised consultancy Spiro Sovereign Strategy.