By Deepa Babington
ROME, July 10 (Reuters) - Italy's government scrambled to present a united front and defend the embattled economy minister on Sunday, hoping to soothe market fears that triggered a sell-off in Italian stocks and bonds last week.
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The sell-off, fueled in part by fears that Economy Minister Giulio Tremonti may be forced out, raised concern that market contagion worries might be shifting to Italy and set off alarm bells in the European Union, the ECB and the Bank of Italy.
The message appeared to have been heard in Rome, where top officials in Prime Minister Silvio Berlusconi's struggling center-right coalition appealed for unity to stop Italy being drawn into market turmoil that has hit Greece and Portugal.
"From tomorrow, we have the job of showing we are united and blocking the effort of speculators," said Paolo Bonaiuti, a government undersecretary and senior aide to Berlusconi.
"In the coming months we have to 120-130 billion euros of bond issues to deal with, so we need cohesion and united intent, it'll take effort to show that the markets are overdoing it."
Berlusconi, facing trial on corruption and sex charges, has been weakened by electoral losses and government infighting and has appeared increasingly at odds with his finance minister. Adding to his woes, a court on Saturday ordered his Fininvest holding company to pay an $800 million penalty to a rival.
Credited with shielding Italy from the worst of the financial crisis, Tremonti has appeared isolated within the government for his hard line on spending cuts.
He has also faced additional pressure after a corruption probe ensnared a close former adviser.
The premium investors demand to hold Italian debt rather than benchmark German bonds hit a euro lifetime high of 236 basis points on Friday after Berlusconi criticised the abrasive Tremonti in a newspaper interview for not being a "team player."
As fears spread that the turmoil hitting Greece could spread to Italy if the budget discipline imposed by Tremonti relaxed, yields on 10-year Italian bonds rose to 5.3 percent, close to what some bankers describe as a pain threshold of 5.5 percent.
At the same time, shares in Italy's biggest bank Unicredit <CRDI.MI> sank 7.9 percent and Italy's blue-chip FTSE MIB index <.FTMIB> fell 3.5 percent.
Euro zone governments have made heavy enough weather of agreeing bailouts for small countries like Greece and Ireland and the consequences of the crisis affecting Italy, the euro zone's third largest economy, are incalculable.
"We can't go on for many more days like Friday," a senior official from the European Central Bank said. "We're very worried by Italy."
OVERCOMING INTERNAL DIVISIONS
The scare on what Italian newspapers called "Black Friday" appears to have strengthened Tremonti's position, with Umberto Bossi, the powerful leader of Berlusconi's Northern League coalition allies, praising him for "listening to the markets."
This week, parliament will begin debating an austerity package aimed at keeping Italy on track to bring its budget back to balance by 2014 and center-right officials urged an end to weeks of squabbling in the ruling coalition.
"The coalition has to avoid internal divisions that must be overcome at all costs and which can be resolved in better times," said Fabrizio Cicchitto from Berlusconi's PDL party.
Berlusconi met Tremonti on Friday for what was officially described afterwards as a "long and cordial" lunch and newspaper commentators expect a truce between the two -- for now.
"The apparent harmony that has been found again is a gesture of responsibility," Massimo Franco, an Italian commentator wrote in the Corriere della Sera newspaper.
"And the unanimous chorus with which the PDL -- usually irritated by his arrogant manner -- defended Tremonti confirms fears of the international consequences of his leaving."
Berlusconi himself was silent over the weekend and canceled two appointments to speak, which Bonaiuti pinned on the Fininvest court ruling.
How far Italian leaders have reassured markets will become clear when Italy taps the bond market on Thursday. Details of the auction will be released Monday. Barclays Capital expects it will be for 7.75 billion euros worth of government bonds.
Officially projected at 120 percent of gross domestic product this year, Italy's gross government debt is the second highest in the European Union, after Greece. But its projected budget deficit of 3.9 percent is below the EU average of 4.7 percent, and its private sector debt is not high.
Italy's 10-year government bond yield, at 5.28 percent, has risen near the 5.5-5.7 percent area that some analysts fear could start pressuring government finances.
It is now only 41 basis points below the yield for Spain, which was considered the next euro zone nation at risk of needing a bailout, but remains far below yields for crisis-hit countries such as Ireland, where the yield is above 13 percent.
(Additional reporting by Andrew Torchia and Brussels bureau)