Prime Minister Silvio Berlusconi's pledge to resign failed to staunch a perilous collapse in market confidence on Wednesday and Italy's borrowing costs raced to catastrophic levels.

Financial markets have been clamouring for weeks for Berlusconi to depart because of his failure to push through painful austerity measures and disarray following from a rebellion inside his own party.

But Berlusconi's pledge on Tuesday night to step down once vital economic reforms are passed instead accelerated the crisis at the centre of the euro zone, with yields on Italy's 10-year bonds shooting above a red line of 7 percent.

Analysts said Italy was now in territory where Greece, Ireland and Portugal were forced to seek bailouts.

The 75-year-old media magnate's insistence that the only way out was elections early next year, and deep political disagreement about the next move only worsened the uncertainty.

An election would put Italy in limbo for several months and there was no sign of agreement on the urgent formation of a transitional government that would likely calm markets.

In another indication of how serious the crisis of confidence is, spreads between Italian government paper and German bunds rose over another watershed of 500 basis points, reaching a record above 560.

President Giorgio Napolitano called for urgent action. Italy must regain credibility and confidence as a country for us first of all to get out from a very dangerous squeeze on financial markets, the head of state said.

With pressure mounting from outside Italy, the opposition called for the budget reforms to be rushed through by November 14.

Italy's centre-left opposition wants the urgent formation of a national unity government but its main leader, Pier Luigi Bersani, said this was unlikely because of resistance from the centre-right. He believed elections were likely.

COUP

Berlusconi and his closest allies say a government of national unity, including the left, or of technocrats would be an undemocratic coup against the last election in 2008.

Berlusconi said that PDL party secretary and former justice minister Angelino Alfano, long his anointed successor, would be the centre-right's candidate for prime minister.

I will resign as soon as the (budget) law is passed and, since I believe there is no other majority possible, I see elections being held at the beginning of February and I will not be a candidate in them, he told La Stampa newspaper.

Italy is in the eye of the euro zone debt storm because, as the region's third largest economy, it is viewed as too big to bail out. Its crisis therefore poses a real threat to the survival of the single currency.

There are wide disagreements among the political parties both about the form of a new government and on budget and structural reforms promised to Europe to bring down Italy's huge debt and improve its economic prospects.

One small opposition group, the Italy of Values party, said on Wednesday it would vote against the reforms.

After failing to secure a majority in a vote in the lower house on Tuesday night, Berlusconi said he would quit as soon as parliament passed the measures. On Wednesday he gave a string of interviews to dispel suspicions that the postponement of his resignation, which is very unusual in Italy, meant he would break his word.

We have to give Europe and the world an urgent, strong signal that we are taking things seriously, he told a morning television show by telephone.

Commentators said the fact that President Giorgio Napolitano had announced the resignation plan in an official statement would make it extremely difficult for Berlusconi to renege on his pledge to stand down.

EU inspectors were in Rome on Wednesday to begin a monitoring mission aimed at ensuring economic reforms are carried out as part of an agreement reached at a G20 summit last week. Most of the reforms are incorporated in the budget measures to be voted on by parliament.

The European Commission sent a letter to Italy this week requesting more details on the reforms and saying additional measures would be needed to meet the target of balancing the budget by 2013.

Napolitano said he would start consultations with all political parties after the new budget measures were approved.

When a government is defeated or resigns, it is the president's duty to appoint a new leader to try to build a majority in parliament, or call an election.

(Additional reporting by Paolo Biondi, Giselda Vagnoni and Stefano Bernabei, Philip Pullella, James Mackenzie and Catherine Hornby; Editing by Robert Woodward)