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By Lisa Jucca
MILAN (Reuters) - Italian government bonds and shares dived on Monday after Silvio Berlusconi pulled the rug from under Enrico Letta's coalition government by ordering five center-right ministers to quit.
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.
Investors fear Italy's political chaos may ripple beyond the country's borders, particularly if new elections result, even though President Giorgio Napolitano appears determined to try all avenues to seek a new parliamentary majority.
The turmoil comes at a doubly unfortunate time as next year's budget law is under negotiations, although the fact that the euro zone economy is showing signs of recovery and investors continue to believe in the European Central Bank's backstop could limit any contagion.
"If it were to come to new elections, still a big if, the ensuing political uncertainty would be bad for Italy and, to a lesser degree for the euro zone," said Holger Schmieding, economist at Berenberg Bank. "But markets and euro zone policymakers are now probably in a better position to deal with it than before."
The yields on Italy's 10-year bond, a good indicator of long-term sentiment towards Italy, spiked to 4.73 percent early on Monday from 4.42 percent on Friday, the highest since June but well below a 7.5 percent yield hit when Italy came on the verge of default in late 2011.
Shares in Milan's blue-chip FTSE MIB plunged 2.5 percent minutes after opening, with banking stocks particularly heavy. Shares in broadcasting group Mediaset, controlled by Silvio Berlusconi, were down nearly 5 percent.
Italian Prime Minister Enrico Letta will go before parliament on Wednesday and hold a confidence vote to verify what is left of his parliamentary backing.
The outcome of a confidence vote is uncertain as some of Berlusconi's lawmakers from his center-right party have shown increasing unease over his shock decision to withdraw government support. Minister Gaetano Quagliarello told an Italian newspaper on Monday there was talk to form another center-right party.
"The resignation of the center-right ministers will clearly increase volatility in the government bond market, similar to what happened between February and April, before the current government was formed," Goldman Sachs analysts said, adding the crisis threatened the few reforms Letta's coalition was trying to push through.
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.
(Editing by Mike Peacock)