Former European commissioner Mario Monti has emerged as favourite to replace Silvio Berlusconi and form a new government to stave off a run on Italian bonds that is endangering the entire euro zone.
Mr Monti, a highly respected international figure, has been pushed by markets for weeks as the most suitable figure to lead a national unity government that will urgently push through painful austerity measures.
In a key development today, Mr Berlusconi's ruling PDL party softened its insistence on early elections as the way out of a deep political crisis and said it was considering the option of a Monti-led government.
President Giorgio Napolitano appointed Mr Monti a senator for life yesterday, in a move widely seen as a sign he would ask the academic to try to form a broad-based government as soon as Mr Berlusconi goes within the next few days.
Italy is under intense pressure to prove it has the political strength to enact measures to increase confidence in its ability to repay its debts, which stand at 120 per cent of GDP. Economic growth is weak and the government failed to enact reforms to revive it over the past decade.
Investors are worried that if Italy's borrowing rates remain too high for too long, it will be blocked out of financial markets and need rescue loans to repay its bondholders. That would be devastating for both the euro and the global
economy.
With Italy's borrowing costs now clearly deep in the danger zone, support for a national unity government appeared to be gaining support among members of the PDL with foreign minister Franco Frattini indicating cautious support.
"The PDL can't just follow the cry for elections from the hard core in support of going to the polls. There's a national interest, which comes before anything," he said in an interview with the Corriere della Sera daily.
The head of the PDL's parliamentary group, Fabrizio Cicchitto said the party was discussing the two options of pressing for elections or supporting a Monti-led government but had not yet reached a decision.
"There's a discussion going on. We have to decide whether to support elections or a Monti government," he said. "We haven't yet untied the knot."
IMF head Christine Lagarde added her voice to calls for an end to the impasse, saying that lack of political clarity in Italy was fuelling uncertainty in the markets.
Mr Napolitano tried desperately to calm markets yesterday after Italy's borrowing costs reached levels that could close its access to market funding, a development which would threaten the future of the euro zone.
He gave assurances that Mr Berlusconi would honour his pledge to step down after parliament approved reforms geared to placate markets. He would then waste no time in either appointing a new government or calling new elections, he said.
However market pressure on Italy continued with yields on its 10 year bonds at around 7.3 per cent yesterday around the levels seen when Ireland, Portugal and Greece were forced to seek a bailout.
The yield eased back to 6.88 per cent by early afternoon today, after a bond sale went better than expected. The government easily sold €5 billion in 12-month bonds at an interest rate of 6.087 per cent. Demand for the bonds was strong, almost twice the amount on sale.
Mr Monti (68), has long been cited as the most likely leader if an emergency executive can gain broad, cross-party support. Such governments have had success in previous crises.
The new administration would then aim to rush through market-friendly reforms, free of political crossfire, although commentators said Mr Monti might still face difficulty getting support for unpopular measures.