Tim Gosling in Prague & Justin Vela in Istanbul -

The euro rallied on the news on Tuesday afternoon that Silvio Berlusconi would resign; by the middle of Wednesday the markets had decided that the political instability adds more risk, and yield's on 10-year Italian debt pushed through the 7% barrier - the level at which Ireland, Portugal and Greece were forced to seek bailouts. The fight is on as the markets push the EU to finally act to shore up the eurozone.

All eyes are now on this morning's auction of one-year bonds, set for 11am, as investors and government's ponder the realistic risk that the eurozone could spin out of control. On the plus side, Italy is still able to service the debt on its EUR1.9 trillion of debt, but the markets are concerned about the country's low rate of growth. Add in political uncertainty, and the scene was set for an attack, which was sparked by LCH Clearnet when it raised the deposit it demands for trading Italian securities.

The recent 50% haircut on Greek debt will be in the back of everyone's mind, with the banks worrying that they could be forced into a similar loss in Italy. Given the level of Rome's debt, that would wreak havoc across the European economy.

"Europe has moved from a manageable crisis in Greece to a much bigger challenge in Italy," Frederic Neumann from HSBC in Hong Kong told the BBC. "We need radical solutions at this point to backstop the markets."

The rise in the cost of borrowing for Italy is essentially a test for the EU, and in particular its glacier-like movement towards hiking the firepower of the EFSF bailout fund. However, even should the rescue facility manage to boost its range to the mooted EUR1 trillion that would unlikely be enough to shore up Italy should the markets stay out. The only option then would be a Chinese (and other emerging market giant) bailout, dressed up in an IMF uniform of course.

The price of such a bailout would be IMF quota reform at the very least, as a senior official at China's central bank reiterated yesterday, but trade and investment conditions would also be demanded, adding impetus to the campaign from the likes of China and Russia to increase their influence in Europe and across the global economy.

Regional markets at risk

The onslaught only increases the risk of a slowdown in the eurozone and greater trouble for the banks, neither of which will be welcome in Central Europe. Yesterday Poland became the third country - after Slovakia and Hungary - in a week to slash its GDP growth forecast for 2012. The likes of the Czech Republic and the Baltics - by far the most exposed to export demand in the eurozone - cannot be far behind, all of them having admitted that their official forecasts will be adapted once there is some clarity on the direction of the European economy.

At the same time, the heightened risk to the banks is also likely to hit the region, dominated as it is by the large Austrian and Italian lenders. Those parents will be forced to act even more conservatively, and will find funding harder to come by, bringing the risk that reduced lending will dampen CEE growth still further.

Shorter term, the region's currencies and funding costs could come under pressure as risk appetite retreats. The Hungarian forint hit a two-year low on Wednesday while the Czech koruna, usually seen as the safe harbor in the region, lost its anchor and drifted to its lowest rate for 18 months, reports WSJ. Analysts at Morgan Stanley promptly lowered their forecast for the currency, saying: "The koruna is likely to continue to suffer as euro-zone sovereign and financial sector stresses dominate market sentiment." Investors will keep a close eye on today's 12-month T bill auction in Budapest, the last of which was cancelled due to low demand.

The bump is likely to be particularly hard in Turkey, with markets returning from a three-day holiday to find themselves in the middle of the chaos that has been gripping global markets this week. Analysts at Erste explained, exhibiting no little restraint, this morning that "this is likely to induce significant volatility in Turkish markets today."

"Bond yields ended last week at 9.8%, started at 9.92% in OTC while the currency started the day at around 1.8 vs. USD/TRY and 2.115 vs. equally weighted EUR+USD basket. CBT is likely to open FX selling auction of higher than USD 50mn today," the report continued.

Thinking the unthinkable?

Meanwhile, back in Brussels the level of tension has reportedly become so high that Reuters reports the unthinkable is being thunk. The newswire reports that, according to unnamed sources, German and French officials are discussing plans for a radical overhaul of the European Union that would involve setting up a more integrated and potentially smaller euro zone.

Whilst the source admitted that the idea has been discussed on an "intellectual" level, but not moved to operational or technical discussions, he claimed that the option of one or more countries leaving the single currency was on the agenda. A French finance ministry spokesman flatly denied the claims, stating: "There have been no conversations between French and German authorities at any level on decreasing the size of the euro zone."

It's clear however that action - whether to solidify or splinter the monetary union - is needed, and the attack on Italy could be read as a message to just that effect from the markets.

Neil McKinnon at VTB Capital suggests "the choice for EU policymakers is simple, though undoubtedly complex from a political perspective. Monetary union in its current format is not viable for as long as Germany rejects a move towards fiscal union and the ECB rejects a role as the lender of last resort. The financial markets see the existing situation as unsustainable and the absence of political co-ordination is worrying. Endless summits and high-profile policy meetings consistently fail to deliver concrete outcomes, despite the promise of high expectations."

More please

At the same time, the commentary from the markets and the banks clearly illustrates just how dearly they would lap up another massive round of quantitive easing, and their actions suggest they are trying to force the issue.

"To provide any chance of averting a deeper crisis and potential break-up in monetary union," McKinnon contends, "the ECB has to announce that it will purchase in unlimited quantity. Estimates of the non-inflation absorption capacity of the Eurozone are put at EUR 3 trillion. The ECB will only be treading where the Fed, BoE and BoJ have already gone."