Former European Commissioner Mario Monti emerged on Thursday as favourite to replace Silvio Berlusconi and form a new government to stave off a run on Italian bonds that is endangering the entire euro zone.
Monti, a highly respected international figure, has been pushed by markets for weeks as the most suitable figure to lead a national unity government that will urgently push through painful austerity measures.
In a key development on Thursday, Berlusconi's ruling PDL party softened its insistence on early elections as the way out of a deep political crisis and said it was considering the option of a Monti-led government.
President Giorgio Napolitano appointed Monti a senator for life on Wednesday, in a move widely seen as a sign he would ask the academic to try to form a broad-based government as soon as Berlusconi goes within the next few days.
With Italy's borrowing costs now clearly deep in the danger zone, support for a national unity government appeared to be gaining support among members of the PDL with Foreign Minister Franco Frattini indicating cautious support.
The PDL can't just follow the cry for elections from the hard core in support of going to the polls. There's a national interest, which comes before anything, he said in an interview with the Corriere della Sera daily.
The head of the PDL's parliamentary group, Fabrizio Cicchitto told Reuters the party was discussing the two options of pressing for elections or supporting a Monti-led government but had not yet reached a decision.
There's a discussion going on. We have to decide whether to support elections or a Monti government, he told Reuters. We haven't yet untied the knot.
The next test of market sentiment is due later on Thursday, when the Treasury is due to offer up to 5 billion euros of 12 month Treasury bills (BOTs). On Wednesday, yields on the 12 month BOTs were over a red line of 7 percent.
IMF head Christine Lagarde added her voice to calls for an end to the impasse, saying that lack of political clarity in Italy was fuelling uncertainty in the markets.
In a highly unusual step, the sober business daily Il Sole 24 Ore carried a huge banner headline reading: Hurry Up, in a call to Italy's political class to forget their own interests and save the country.
Napolitano tried desperately to calm markets on Wednesday after Italy's borrowing costs reached levels that could close its access to market funding, a development which would threaten the future of the euro zone.
He gave assurances that Berlusconi would honour his pledge to step down after parliament approved reforms geared to placate markets. He would then waste no time in either appointing a new government or calling new elections, he said.
However market pressure on Italy continued with yields on its 10 year bonds at around 7.3 percent, around the levels seen when Ireland, Portugal and Greece were forced to seek a bailout.
Monti, 68, has long been cited as the most likely leader if an emergency executive can gain broad, cross-party support. Such governments have had success in previous crises.
The new administration would then aim to rush through market-friendly reforms, free of political crossfire, although commentators said Monti might still face difficulty getting support for unpopular measures.
Commentator Ferruccio de Bortoli described Napolitano's appointment of Monti to the Senate as a sensational turnaround that was indispensable after the dramatic market reaction on Wednesday.
But the road from here is very much uphill. There are several unknowns, starting with the political forces that will have to support a possible technical government, de Bortoli wrote in the Corriere della Sera.
Berlusconi, who has said he sees new elections as the only realistic next step, countersigned Monti's appointment, which was made formally for his past services to the country, a statement from Napolitano's office said.
Media said Berlusconi may now be open to the idea of a Monti government -- something he previously strongly opposed.
Monti, a respected economist who is currently head of Milan's prestigious Bocconi university, is a tough negotiator with a record of taking on powerful corporate interests as European Competition Commissioner.
A Monti-led government is seen as the preferred option by investors, though it may be too late to turn markets around with the borrowing costs of the euro zone's third biggest economy already looking out of control.
With markets fixated on the political chaos in Italy, lawmakers are racing to pass the package of budget and reform measures that Berlusconi has pledged to see through parliament before he steps down.
Lower House Speaker Gianfranco Fini said that parliament would pass reforms by Sunday aimed at boosting growth and shoring up public finances in a so-called maxi amendment to the 2012 budget currently before parliament.
Those reforms, which Berlusconi promised to Italy's increasingly worried partners last month, will be the government's last piece of business before the prime minister tenders his resignation.
(Editing by James Mackenzie and Barry Moody)