Italian stocks are rallying on reports that all the members of Silvio Berlusconi's "People of Liberty" (PdL) party are ready to back Prime Minister Enrico Letta in a vote of confidence on Wednesday.
Italy's FTSEMIB (FTSE International: .FTMIB-GB) hit a two-year high after Letta had delivered a strong speech to the Italian Senate on why he should stay in office.
Letta warned lawmakers of a 'fatal' risk to the country's political and economic future in Wednesday's vote of confidence in his coalition government.
"Italy is now running a risk that could be fatal, overcoming this risk depends on us and on the choices that we make, it depends on a yes or no [vote]," Letta told parliament in a televised address Wednesday morning, insisting that the Italian economy and political stability were his priorities.
On arriving at the Senate Wednesday morning, former prime minister, and leader of Letta's rival coalition party, Silvio Berlusconi told reporters he had yet to decide whether to support the government despite an increasing number of his party looking set to rebel against him by backing Letta.
It would be an embarrassing defeat for former prime minister Berlusconi at the hands of his own party if the vote, expected to be held on Wednesday after Letta has addressed both the Senate and upper house of parliament, goes against him.
Tensions within the coalition government between Letta's "Democratic party" (PD) center-left party and Berlusconi's right-wing "People of Liberty" (PdL) party came to a head at the weekend when the ex-prime minister ordered the resignation of five cabinet ministers from the fragile coalition government. In response, Letta called the confidence vote in an attempt to avoid a fresh election only eight months after the last one.
Italian stocks fell at the start of the week at the threat of further political instability.
(Read more: Italy PM Letta faces showdown )
Berlusconi's attempts to break up the coalition have not met with the full backing of his party. His deputy and party secretary Angelino Alfano said on Tuesday that members of Berlusconi's PdL party should back Letta. Media reports also suggest there are around 40 senators within Berlusconi's camp that could defy him to support Letta.
Alfano's apparent defiance of his leader prompted Italian newspaper 'Il Giornale' (run by Berlusconi's brother) to call Alfano a "traitor" on Wednesday, but one senior market analyst warned that Berlusconi ignored the dissenting voices within his own party at his peril.
"One can only imagine what Berlusconi thought of that, and hopefully Mr Alfano doesn't find a horse's head in his bed, but if enough of Berlusconi's party were to articulate a similar view when voting then the former prime minister could well be left out in the cold," Michael Hewson from CMC Markets said.
"Berlusconi has insisted that the PDL must vote against Letta in any vote in defiance of the nearly 30-40 MP's who it has been suggested have a different view. It's a high risk strategy by Berlusconi which could backfire on him badly."
With such pressure to toe the line, one analyst said it remained to be seen how many of Berlusconi's supporters would actually rebel when it came to the vote.
Wolfango Piccoli, managing director of Teneo Intelligence said ahead of the vote: "Potential dissenters will be mindful about the fate of those who defied Berlusconi's line in the past: so far, defection from Berlusconi's line has meant the end of the political career."
(Read more: Silvio Berlusconi's 'Greatest'Hits )
A victory for Letta would allow him to remain in office on a thinner parliamentary majority, Piccoli added. But if he does not survive the vote, Italy could be thrown into further disarray with the formation of a new coalition or a technocratic government.
If those solutions could not be found, parliament would have to be dissolved and new elections called, he noted.
Berlusconi is also under increasing pressure as he faces a Senate vote on Friday on whether to expel him from politics for a tax fraud conviction he received in August.
Though his hardline stance against the government comes partly in response to this possible expulsion, it is also a result of opposition to plans to increase the country's sales tax in 2014.
Despite the youth of the coalition - patched together 8 weeks after the inconclusive elections in April -- the sales tax disagreement is merely the latest in a long line of disagreements and delays in the coalition over economic reforms and tax increases.
In the meantime, Italy's economy continues to suffer from the infighting with borrowing costs rising and market turmoil following the shock announcement at the weekend. Adding insult to injury, on Tuesday Italy's Treasury posted a state sector budget deficit of 15.5 billion euros ($20.9 billion) in September, widening sharply from a 11.4-billion-euro shortfall in the same month last year.
- By CNBC's Holly Ellyatt, follow her on Twitter @HollyEllyatt
Follow us on Twitter: @CNBCWorld
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