UPDATE 4-Italy shares, bonds slide on political paralysis fears
* Italian bonds, shares tumble on political gridlock
* Italy forced to pay 50 bps more to sell 6-month bills
* Bigger test on Wednesday when Italy offers 10-yr bonds
* Market regulator halts short selling of shares in two banks
By Lisa Jucca and Francesca Landini
MILAN, Feb 26 (Reuters) - Italian stocks and government bonds fell sharply on Tuesday, after a parliamentary election left Italy facing political deadlock and rekindled fears of a new euro zone debt crisis.
Shares in the main stock market index fell nearly 4 percent, dragged down by losses of 7 percent or more on banks such as Intesa Sanpaolo and UniCredit, big holders of Italy's 2-trillion euro ($2.6-trillion) state debt.
The regulator stepped in to curb volatility by banning short selling of stock in Intesa and smaller bank Carige for two days.
The premium the Italian government pays compared to Germany to borrow for 10 years widened to a level not seen in two and a half months, hitting a yield spread of 348 basis points in early trading. It stood at 333 at 1405 GMT, compared to 283 at the official Italian market close on Monday.
At an auction of six-month BOT treasury bills, creditors demanded half a percentage point more to lend to the Italian state than they did at a similar sale a month ago.
"(The) Italian election is the pivotal political event for the euro zone this year, and has produced divided government in an outcome negative for political stability," Citi analysts said in a note to clients.
"The high political uncertainty that is likely to persist in the coming period will likely have a negative impact on real and financial investment decisions in Italy."
The treasury had to pay a yield of 1.24 percent to sell six-month BOT bills at auction on Tuesday, a hefty 50 basis points more than at the last similar sale in January.
"Obviously everything spiked because of the political uncertainty on whether they are going to have to go to polls again or whether they will be able to form some kind of a grand coalition," said Lyn Graham-Taylor, rate strategist at Rabobank in London.
Rome will face a challenge on Wednesday, when it offers the market up to 6.5 billion euros of 5-year and 10-year bonds.
Neither is covered by the three-year safety net that the European Central Bank would provide through its bond-buying programme were Italy forced to ask for international aid and analysts expect foreign investors to stay away.
Italy's messy vote, which gave a majority to the centre-left in the lower house but no clear control of the Senate to any party, sent shockwaves across the main euro zone markets, dragging Paris and Frankfurt down and pulling the euro to a seven-week low against the dollar.
Traders and analysts said the divided parliament and the massive surge of what they see as an anti-austerity vote embodied by the meteoric rise of comedian Beppe Grillo's 5-Star Movement and by the success of Silvio Berlusconi's conservative bloc was "the worst possible outcome" for markets.
Yet, suggestions by Berlusconi that he may be open to do a deal with the centre-left Democratic Party of Pierluigi Bersani helped reduce some of the initial losses.
"Italy cannot be left ungoverned. We have to reflect," the media tycoon and former prime minister said.
Berlusconi, who staged an impressive comeback by attacking the reform programme of technocrat premier Mario Monti, ruled out a deal with the internationally respected economist.
The Italian confusion also sparked a sell-off of vulnerable Spanish and Portuguese bonds.
Analysts see no quick fix for Italy, the euro zone's third largest economy, which is stuck in recession.
"The bottom line is that political instability is likely to prevail in the near term and slow the implementation of much needed structural reforms unless a grand coalition among the centre left's Democratic Party, Berlusconi and the centrists is formed," said Barclays economist Fabio Fois.
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