The euro region's defenses are being breached.

Investors yesterday propelled Italy's 10-year bond yield toclose at a euro-era high of 7.25 percent after the promised exit ofPrime Minister Silvio Berlusconi failed to convince them that hiscountry can slash Europe's second-largest debt burden.

The biggest signal yet that the single currency's third-largesteconomy is falling prey to its two-year debt crisis forces GermanChancellor Angela Merkel, European Central Bank President MarioDraghi and their peers to decide just how far they're willing to goto defend the euro.

“The market is testing the commitment of the euro zone'sstewards,” said Eric Chaney, Paris-based chief economist at insurerAXA SA and a former official in the French Finance Ministry. “Italyis the real crisis battleground.”

The euro strengthened against the dollar today, after earlierreaching a one month low, and traded at $1.3565 as of 9:22 a.m. inLondon.

Italian 10-year bonds rebounded from declines as the ECB boughtthe country's debt, according to three people familiar with thetransactions, who declined to be identified because the deals areconfidential. The 10-year yield slipped to 7.1 percent, still at alevel which previously drove Greece, Ireland and Portugal to seekbailouts.

At 1.9 trillion euros ($2.6 trillion), Italy's debt exceeds thatof Greece, Spain, Portugal and Ireland combined, though unlikethose nations, it has systemic importance as the world'sthird-largest bond market and eighth-biggest economy.

Berlusconi's offer to quit has still left his nation strugglingto produce a government stable enough to deliver austerity afterLCH Clearnet SA raised the deposit it demands for trading Italiansecurities. Investor sentiment will be tested today as Italy sells5 billion euros ($6.8 billion) of one-year bills.

“While Italy is considered too big to fail, she may be too bigto save unless there is a major change of attitude towardsresolving the crisis,” said John Higgins, an economist at CapitalEconomics Ltd. in London. “Things could be about to turn veryugly.”

Pressure Builds

Investors want “a signal that Italy has taken control of itsaccounts and is increasing the competitiveness of the system,”Marco Tronchetti Provera, Chairman of Pirelli & C. SpA,Europe's third-biggest maker of tires, told reporters in Londonyesterday. “Parliament has to take action soon.”

Global pressure on Rome is building days after Group of 20leaders decried the inability of European counterparts to defeat acrisis now in its third year and threatening global growth.

Deputy finance ministers meeting at the Asia-Pacific EconomicCooperation forum in Honolulu today expressed concern over thedanger Europe poses to the world economy. U.S. TreasuryUndersecretary for International Affairs Lael Brainard saidyesterday that European officials must speed up construction of a“firewall” to protect countries that have sound policies.

International Monetary Fund fiscal monitors are due to visit theItalian capital, and European Union Economic and Monetary AffairsCommissioner Olli Rehn says he wants answers to “very specificquestions” on economic pledges by the weekend. U.K. Prime MinisterDavid Cameron yesterday said Italian interest rates are “getting toa totally unsustainable level.”

“This is a form of meltdown,” said Marc Ostwald, a fixed-incomestrategist at Monument Securities Ltd. in London. “I would imaginethe telephones between international finance ministries and centralbanks are in danger of running so hot they'll melt downthemselves.”

Spooked by the investor selloff, Italy's Senate rushed to set upa vote tomorrow on a package of debt-reduction measures whichshould pave the way for a Nov. 12 vote in the Chamber of Deputiesand then Berlusconi's departure. The premier is still seekingelections which may delay further reforms.

Failure to restore order may leave Italy joining Greece,Portugal and Ireland in seeking outside help. The first port ofcall would likely be the 440-billion euro European FinancialStability Facility. A country can now tap a precautionary promiseof support of up to 10 percent of its gross domestic product —about 160 billion euros in Italy's case.

German Finance Minister Wolfgang Schaeuble yesterday toldlawmakers that Italy should request aid from the EFSF if it needsit, two people present at the Berlin meeting said.

EFSF Backstop

Higgins at Capital Economics said Italy needs about 650 billioneuros to keep out of markets for the next three years, rising to700 billion euros with support for its banks. Another alternativeis the EFSF buys Italian bonds in markets, he said.

A problem is that the rescue fund has about 270 billion eurosleft after subtracting commitments to Greece, Portugal and Ireland.Governments also have yet to flesh out last month's promise toboost its spending power to 1 trillion euros. With Italy facingbond maturities of about 475 billion euros in the next three years,Citigroup Inc. and Royal Bank of Scotland Group Plc are among thosesaying the fund needs at least double that amount to insulate Italyand Spain.

“It's hard to see that Europe would have the resources to take acountry the size of Italy into the bailout program,” Finnish PrimeMinister Jyrki Katainen said this week.

Such dilemmas could push Italy into the arms of the IMF, daysafter Berlusconi said he turned down a credit line with theWashington-based lender. With G-20 leaders debating whether and howto boost the IMF's $391 billion war chest to assist Europe'scrisis-fighting, Managing Director Christine Lagarde yesterdaywarned of a potential “lost decade” for the world economy.

“The bazooka approach would be an IMF-led solution backed by theU.S., China and others,” said Fredrik Erixon, head of the EuropeanCentre for International Political Economy in Brussels.

There is mounting pressure on the Frankfurt-based ECB –nowhelmed by the Italian Draghi — to bolster a bond-buying programwhich it deployed as recently as yesterday to ease Italy's strains.Another proposal is for the central bank to provide an unlimitedguarantee of Italy's debt in the hope that would remind investorsit's struggling with liquidity not insolvency and to buy it time topass debt-reducing policies.

“The house is on fire,” said Dante Roscini, a lecturer atHarvard Business School and former chief executive officer ofMorgan Stanley in Italy. “The ECB needs to print money and buyItalian bonds, it's the only way to put the fire out.”

The time may still not have come for the ECB to power up, givencentral bankers would first want Italy to earn support by showinghow it will eventually deliver budget discipline, said Ken Wattret,chief euro-zone market economist at BNP Paribas SA.

'Limited' Intervention

“The ECB will only intervene in a limited way when there's aclearer path towards a more fundamental overhaul of the economy,”he said.

Internal politics and ideology may stay the ECB's handpermanently despite its prior willingness to rewrite its rulebook.Since May 2010 the ECB has limited its bond buying to 183 billion,and Bundesbank President Jens Weidmann this week said the centralbank cannot bail governments out, citing Germany's experience ofhyperinflation after World War I.

“The only thing that would be a real game changer would be ifthe ECB were to take up this idea of being a lender of last resortto governments, but printing money is against the ECB's religion,”said Nick Kounis, head of macro research at ABN Amro Bank NV inAmsterdam.

If the central bankers do eventually turn to the printing pressit may be part of a broader strategic effort to finally conquer theturmoil which includes Greece being ejected from the euro area,said Eoin Fahy, chief economist at Kleinwort Benson Investors inDublin. Merkel and French President Nicolas Sarkozy said last weekfor the first time that a country could leave the euro area if itfails to live by its rules.

“Eventually they'll get to that point where they have to press'print,'” Fahy said. “The question is, do they throw Greece to thewolves first?”

Italy may still not need saving. IHS Global Insight economistRaj Badiani says the government can survive “several quarters ofexpensive debt auctions” thanks to positive cash flow andrelatively low levels of private debt. BlackRock Inc., the world'sbiggest money manager, said yesterday it's “comfortable” holdingintermediate Italian bonds.

Andrew Bosomworth, a senior portfolio manager at PacificInvestment Management Co. in Munich, senses a “watershed moment.”With Italy all but locked out of markets, European officials mayhave to jettison their short-term firefighting and pick between asmaller, stronger euro zone or a federalist structure with greatercross-border support.

“What is happening is what they've been trying to stop,” saidBosomworth, a former ECB economist.

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