ROME Italy has come under a market spotlight at the worst possible moment, when bitter political infighting and a decline in the strength of Prime Minister Silvio Berlusconi herald a period of new instability.
Berlusconi is not only facing three corruption trials and a lurid sex scandal but a stunning setback in local elections last week that has unleashed divisions in his ruling alliance.
This is likely to reduce prospects for the very economic reforms which ratings agency Standard & Poors urged at the weekend when it cut its outlook for the euro zone's third largest economy to negative from stable.
Although the two other ratings agencies, Moody's and Fitch, maintained a stable outlook, S&P's warning focused attention on Italy's massive debt -- among the biggest in the world -- and its chronically weak growth for more than a decade.
The spread between the yield on Italian and German government bonds hit its widest level since January on Monday and the cost of insuring Italian government debt rose.
While analysts believe the reaction will be shortlived, S&P seemed to be aiming very directly at Italy's government, whose failure to liberalize the economy and rigid labor market looks like being aggravated by Berlusconi's problems.
"The S&P negative outlook should be regarded mostly as a wake-up call for the Italian government," Unicredit said in a research note.
"Berlusconi, because of his plunging popularity, is reluctant to take up what would be a very unpopular reform agenda that could result in job losses and falling incomes," said Raj Badiani from IHS Global Insight.
Italy, widely seen as too big to fail, has been largely cushioned from the euro zone debt crisis because of the prudent fiscal policy led by Economy Minister Giulio Tremonti and its low levels of private debt.
But with pressure mounting on all but the strongest euro economies, containing spending may no longer be enough. The spotlight has now turned on the need to revive what the IMF says was the world's fourth most sluggish economy between 2000 and 2010, ahead only of Zimbabwe, Eritrea and Haiti.
Without growth and an increase in government revenue there will be no chance of reducing Italy's public debt, expected to hit 120 percent of GDP this year.
Berlusconi, the dominant figure in Italian politics for nearly two decades, suffered a serious setback in the first round of local elections a week ago when the center-right mayor was forced into a run-off in the financial capital of Milan for the first time in 14 years.
Most significantly, the poor result in his hometown and stronghold of his People of Freedom party seemed due to a major miscalculation by Berlusconi himself, who turned the campaign into a personal vote and bombarded the air waves with rhetoric, much of it attacking the magistrates who accuse him.
Despite years of public gaffes, Berlusconi has widely been seen as a consummate political operator and the only viable candidate for the dominant conservative voting bloc in Italy.
Commentators predicted that if the center-right fails to keep Milan in the run-offs next Sunday and Monday, it will signal the beginning of the end of "berlusconism" and a period of deep uncertainty likely to further paralyze economic reform.
The first round of the polls also undermined the alliance with the anti-immigrant, pro-devolution Northern League on which Berlusconi depends for survival following a split in the PDL.
The League also suffered in the elections and quickly blamed Berlusconi and his attempts to pass laws to evade a string of concurrent trials for corruption and paying for sex with an underage prostitute.
Over the weekend the row worsened, with Berlusconi forced to deny League claims that two ministries would be transferred to Milan -- prompting opposition mockery that the government would try to move the ancient Roman Colosseum there as well.
Bitter campaigning, including fights between rival supporters in Milan, reflect how much is at stake and Berlusconi's rhetoric has become ever more heated.
After falling into a stunned silence for nearly a week after the first vote, he returned to the fray with a storm of allegations that the leftwing candidate in Milan was an extremist who would turn the city into Italy's "Stalingrad."
On Monday he went further, suggesting that under a leftwing mayor Milan would become "an Islamic city, a gypsy metropolis, full of Roma camps and besieged by foreigners to whom the left would give a vote."
Analysts say Berlusconi has finally lost touch with electors who brought him to power and who have been badly hit by a real decline in living standards and rising unemployment.
"The fact is that Berlusconi and his people can no longer give a voice to their hinterland and express their point of view about how the country should be run," said Ernesto Galli Della Loggia in the Corriere Della Sera newspaper
(Additional reporting by Silvia Aloisi, editing by Gavin Jones)