MILAN (Reuters) - Italian bond yields shot higher, domestic shares tumbled and the euro slipped on Monday on fears that Italy's economic reforms will stall after Prime Minister Mario Monti said he would quit office early.
The unelected technocrat, an economist respected by international investors, said on Saturday he would resign once the 2013 budget is approved. He had lost the support of Silvio Berlusconi's center-right PDL party, the largest in parliament.
Coupled with Berlusconi's announcement that he would run for office again, news of Monti's early departure sparked fears Italy could stray from the reform path championed by the former European Commissioner after elections now expected in February.
"Monti has been seen as a safe pair of hands across financial markets and in pro-austerity countries like Germany," said Ishaq Siddiqi, market strategist at ETX Capital.
"His departure ... leaves the void to be filled by parties, such as that of ex-Italian prime minister Silvio Berlusconi, who are very critical of Monti's government."
Monti's austerity drive, which included higher taxes, has been praised by European politicians but sparked anger among ordinary Italians struggling with a painful economic crisis.
Opinion polls suggest a stable pro-European government led by the center-left PD party will replace Monti's technocrats.
But the sudden acceleration in the political crisis over the weekend was enough to put Italy back into the spotlight of the euro zone crisis alongside Spain, whose yields also climbed on Monday on the back of the turmoil in Rome.
The difference in yields between Italy's 10-year benchmark bonds and their safer German equivalents leapt nearly 40 basis points to 363 basis points, the highest in a month. But the premium remained well below the record 574 basis points hit at the height of the euro zone crisis a year ago.
The European Central Bank's pledge to start buying bonds of euro zone countries in need had helped Italian borrowing costs fall back to pre-crisis level in November. But that "deceptive calm" has gone, said sovereign bond analyst Nicholas Spiro.
"If the spread goes back above 400-450 basis points, Italian banks will find it very difficult to access the wholesale market," said a senior Italian economist.
Italy will have completed its refinancing for the year after this week's debt auctions, which remain on schedule despite Monti's move, a source close to the treasury told Reuters. But with a mammoth 2 trillion euros of debt to service, the country will still need to raise 420 billion euros next year.
The main Italian share index dived more than 3.5 percent .FTMIB, underperforming shares in Paris, Frankfurt and London. Italian banks were hit hardest due to their Italian government bond holdings, which stood at 340 billion euros in October.
Banca Monte dei Paschi di Siena (BMPS.MI), the weakest of Italy's five systemic banks, fell more than 7 percent and trading was suspended at one point due to excess volatility.
The bank needs parliament's green light for nearly 4 billion euros ($5.17 billion) of state aid. Its last chance to get the aid is if this is approved together with the budget law, the final parliament act Monti is ready to oversee before quitting.
The euro dipped 0.1 percent to $1.2910, not far from a two-week low of $1.2876, and was seen as susceptible to further losses.
The picture could be further complicated if international ratings agencies that have placed Italy under review for a possible downgrade were to pull the trigger.
Standard & Poor's confirmed its negative outlook on Friday and said it could cut its rating if the country does not manage to recover from its recession in 2013.
But some analysts and senior Italian bankers say market jitters would abate if it becomes clear the Italians will elect a pro-Europe government, as polls currently indicate.
Pierluigi Bersani, at the helm of Italy's center-left coalition, is a committed pro-European. But he faces populist challenges from Berlusconi and the anti-austerity 5-Star Movement, led by former comedian Beppe Grillo.
"At present, the most probable outcome remains that of a center-left coalition government, with Monti involved in some institutional role. This would broadly see a continuation of policies introduced by the Monti government," said Francesco Garzarelli, an analyst at Goldman Sachs.
Monti, called in a year ago to replace Berlusconi and guide Italy out of an acute financial crisis, has not yet decided whether he will continue to play a political role.
European Council President Herman Van Rompuy said whoever replaces him must continue reforms and budget consolidation to restore confidence in Italy and the euro zone.
"There is a lot of noise right now, and it will continue for a few days. But in practice not much has changed and we are heading towards a center-left, pro-Europe government," said a top Italian banker.
Writing by Lisa Jucca; Additional reporting by Francesca Landini; Editing by Catherine Evans