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European Commission President Jose Manuel Barroso issued a stern warning of the dangers of splitting the zone, rocked by an escalating debt crisis. EU sources told Reuters French and German officials had held discussions on just such a move.

"There cannot be peace and prosperity in the North or in the West of Europe, if there is no peace and prosperity in the South or in the East," Barroso said.

Italian 10-year bond yields shot above the 7 percent level that is widely deemed unsustainable, reflecting an evaporation of investor confidence and prompting German Chancellor Angela Merkel to issue a call to arms.

Merkel said Europe's plight was now so "unpleasant" that deep structural reforms were needed quickly, warning the rest of the world would not wait. "That will mean more Europe, not less Europe," she told a conference in Berlin.

She called for changes in EU treaties after French President Nicolas Sarkozy advocated a two-speed Europe in which euro zone countries accelerate and deepen integration while an expanding group outside the currency bloc stays more loosely connected -- a signal that some members may have to quit the euro.

"It is time for a breakthrough to a new Europe," Merkel said. "A community that says, regardless of what happens in the rest of the world, that it can never again change its ground rules, that community simply can't survive."

The European Central Bank, the only effective bulwark against market attacks, intervened to buy Italian bonds in large amounts but remained reluctant to go further.

Italy has replaced Greece at the center of the crisis and is on the cusp of needing a bailout that Europe cannot afford.

"Financial assistance is not in the cards," one euro zone official said, adding that the bloc was not even considering extending a precautionary credit line to Rome.

Having lost his majority in a parliamentary vote, Berlusconi confirmed he would resign after implementing economic reforms demanded by the European Union, and said Italy must then hold an election in which he would not stand.

He opposed any form of transitional or unity government -- which the opposition and many in the markets favor -- and said polls were not likely until February, leaving a three-month policy vacuum in which markets could create havoc.

Italian President Giorgio Napolitano said there was no doubt about the resignation of Berlusconi once economic reforms were implemented by parliament within days.

"Therefore, within a short time either a new government will be formed...or parliament will be dissolved to immediately begin an electoral campaign," Napolitano said.

Even with the exit of a man who came to symbolize scandal and empty promises, it will not be easy for Italy to convince markets it can cut its huge debt, liberalize the labor market, attack tax evasion and boost productivity.

Worries that the debt crisis could be infiltrating the core of the euro zone were reflected in the spread of 10-year French government bonds over their German equivalent blowing out to a euro era high around 140 basis points.

FRUSTRATION

Policymakers outside the euro area kept up pressure for more decisive action to stop the crisis spreading.

Christine Lagarde, head of the International Monetary Fund, told a financial forum in Beijing that Europe's debt crisis risked plunging the global economy into a Japan-style "lost decade."

"If we do not act boldly and if we do not act together, the economy around the world runs the risk of downward spiral of uncertainty, financial instability and potential collapse of global demand."

Berlusconi has reluctantly conceded that the IMF can oversee Italian reform efforts.

Euro zone finance ministers agreed on Monday on a road map for leveraging the 17-nation currency bloc's 440-billion-euro ($600 billion) rescue fund to shield larger economies like Italy and Spain from a possible Greek default.

But there are doubts about the efficacy of those complex plans, and with Italy's debt totaling around 1.9 trillion euros even a larger bailout fund could struggle to cope.

Lagarde said she was hopeful the technical details on boosting the European Financial Stability Fund (EFSF) to around 1 trillion euros would be ready by December.

Many outside Europe are calling on the ECB to take a more active role as other major central banks do in acting as lender of last resort. German opposition to that remains implacable, seeing it as a threat to the central bank's independence.

"The ECB will be drawn like everyone else by the weight of gravity (to act)," one euro zone official said.

"CORE" ZONE DISCUSSED

EU sources told Reuters German and French officials had discussed plans for a radical overhaul of the European Union that would involve establishing a more integrated and potentially smaller euro zone.

The discussions among policymakers in Paris, Berlin and Brussels raise the possibility of one or more countries leaving the zone, while the core pushes to deeper economic integration.

In a speech in Berlin, Barroso said Germany's gross domestic product could contract by 3 percent if the 17-member zone shrank and its economy would shed a million jobs.

"What is more, it would jeopardize the future prosperity of the next generation," he said.

Barroso said any push toward deeper integration should not come at the price of new divisions among EU member states.

GREEK DRAMA

With the markets' fire turned firmly on Italy, Greece's struggle to find a new prime minister became something of a sideshow, but one which demonstrated the difficulty in taking decisive action anywhere within the euro zone.

Greek Prime Minister George Papandreou said he was stepping down without saying who would succeed him as the nation heads toward bankruptcy, but party sources said leaders had agreed it would be the speaker of parliament.

Parties from left and right settled on veteran socialist Filippos Petsalnikos, barring-last minute snags, the sources said, turning to their own political class after ditching a plan to recruit a former top European Central Bank official.

The socialist and conservative parties had wanted former ECB vice-president Lucas Papademos to lead a government of national unity but he appears to have made demands about his level of influence which they could not swallow.

(Additional reporting by Dina Kyriakidou and Lefteris Papadimas in Athens, Emelia Sithole-Matarise, Kirsten Donovan and William James in London; Writing by Mike Peacock; Editing by Janet McBride and Andrew Roche)

Italian borrowing costs reached a breaking point, hitting 7.5 percent as Prime Minister Silvio Berlusconi's promise to resign failed to raise optimism about the country's ability to deliver on long-promised economic reforms.

Italy has replaced Greece at the center of the euro zone debt crisis and is teetering on the cusp of requiring a bailout that many say Europe cannot afford to give.

Portugal and Ireland were forced to seek bailouts when their borrowing costs reached similar levels.

"You are dealing with a pretty substantial economy, you are not dealing with a Greek economy, you are dealing with something that is far more significant," said Barry Ritholtz, chief market strategist at Fusion IQ in New York.

"I don't think Italy can just walk away, they can't simply default whereas Greece can, because if they do that is the end of the euro."

By midday, European stocks were lower by 2 percent after an early rally that had been ignited by Berlusconi's announcement to step down.

Adding to worries about the region, a plan for a former European Central Bank official to lead a Greek coalition government ran into trouble, sources said, as the nation sought to head off a feared bankruptcy.

S&P 500 futures slumped 27.6 points and were well below fair value, a formula that evaluates pricing by taking into account interest rates, dividends and time to expiration of the contract. Dow Jones industrial average futures lost 213 points while Nasdaq 100 futures dropped 46.75 points.

Adobe Systems Inc fell nearly 10 percent to $27.50 in premarket trade after the software maker said it plans to lay off more than 7 percent of its workforce.

General Motors Co slid 3.8 percent to $24.08 after the automaker said it expects to miss its target for the year to break even in Europe due to deteriorating conditions in the region.

After the closing bell, Cisco Systems Inc, the maker of Internet networking gear, will report quarterly results. Shares were off 1.4 percent to $18.05 premarket.

On the economic front, the Commerce Department releases wholesale inventories for September at 10 a.m. EST (1500 GMT). Economists forecast inventories to rise 0.5 percent versus a 0.4 percent increase in August.

U.S. Federal Reserve Chairman Ben Bernanke will speak at a small business and entrepreneurship conference at 9:30 a.m. EST (1430 GMT).

(Reporting by Chuck Mikolajczak; editing by Jeffrey Benkoe)

Italian 10-year bond yields shot above the 7 percent level that is widely deemed unsustainable, reflecting investors' concerns that they may not get their money back, a fear that also showed up in a jump in the cost of insuring against Italian debt default.

Portugal and Ireland were forced to seek EU-IMF bailouts when their borrowing costs reached similar levels and clearing house LCH.Clearnet sounded another alarm by increasing the margin it demands on debt from the euro zone's third largest country, effectively raising the cost of holding its bonds.

The European Central Bank, the only effective bulwark against market attacks on the euro zone, wasted no time intervening to buy Italian bonds, traders said.

"The ECB is buying in decent sizes," a London hedge fund investor said. "It makes you wonder how much firepower it has. It's scary. The market was a bit naive when Berlusconi left. Now it realizes there's a mountain to climb."

Italy has replaced Greece at the center of the euro zone debt crisis and is teetering on the cusp of requiring a bailout that Europe cannot afford to give.

Having lost his majority in a key parliamentary vote, Berlusconi confirmed he would resign after implementing urgent economic reforms demanded by the European Union, and said Italy must then hold an election, in which he would not stand.

He opposed any form of transitional or national unity government -- which the opposition and many on the markets favor -- and said polls were not likely until February, leaving a three-month policy vacuum in which markets could create havoc.

Even with the exit of a man who came to symbolize scandal and empty promises, it will not be easy for Italy to convince markets it can cut its huge debt, liberalize the labor market, attack tax evasion and boost productivity.

"There is no guarantee (Berlusconi's) successor will be able to do a better job. Just keep your eyes on the Italian yield for now," Christian Jimenez, fund manager and president of Diamant Bleu Gestion, said.

FRUSTRATION

Policymakers outside the euro area kept up a chorus of pressure for more decisive action to stop the crisis spreading.

Christine Lagarde, head of the International Monetary Fund, told a financial forum in Beijing that Europe's debt crisis risked plunging the global economy into a Japan-style "lost decade" and said it was up to rich nations to shoulder the burden of restoring growth and confidence.

"Our sense is that if we do not act boldly and if we do not act together, the economy around the world runs the risk of downward spiral of uncertainty, financial instability and potential collapse of global demand... we could run the risk of what some commentators are already calling the lost decade."

Berlusconi has reluctantly conceded that the IMF can oversee Italian reform efforts.

Euro zone finance ministers agreed on Monday on a roadmap for boosting the 17-nation currency bloc's 440-billion-euro ($600 billion) rescue fund to shield larger economies like Italy and Spain from a possible Greek default.

But with bond investors increasingly on strike, there are doubts about the efficacy of those complex leveraging plans, and with Italy's debt totaling around 1.9 trillion euros even a larger bailout fund could struggle to cope.

Lagarde said she was hopeful that the technical details of an EU plan to boost the European Financial Stability Fund (EFSF) to around 1 trillion euros would be ready by December.

Many outside Europe cannot understand why the ECB does not take a more active role as other major central banks do in acting as lender of last resort. German opposition to that remains implacable, seeing it as a threat to the central bank's independence from politics.

German central bank chief Jens Weidmann, a key member of the ECB, rejected a separate proposal to use national gold and currency reserves or IMF special drawing rights to boost the bailout fund, welcoming opposition from Chancellor Angela Merkel to the same.

But with the ECB just about the only buyer of Italian bonds, according to traders, it may have to act more aggressively to contain the latest wave of crisis, despite internal opposition to its bond-buying program.

It could call on limitless power if it began printing money as the Federal Reserve and Bank of England have. But for it, and Berlin, that is a step too far.

GREEK STANDOFF

With the markets' fire turned firmly on Italy, Greece's struggle to find a new prime minister became something of a sideshow, but one which demonstrated the difficulty in taking decisive action anywhere within the euro zone.

Greek political leaders scrambled to agree on a new premier to lead the country back from the brink of bankruptcy, after a plan to name a former European Central Bank official appeared to fall apart.

In the past two days government sources have made a number of optimistic predictions about forming the government, which must secure a 130-billion-euro ($180-billion) bailout from the euro zone, only for no deal to materialize.

The socialist and conservative parties had wanted former ECB vice-president Lucas Papademos to lead a government of national unity, aiming to re-establish an international credibility that the politicians lost long ago.

But he appears to have made demands about his level of influence which they could not swallow.

(Additional reporting by Renee Maltezou and Angeliki Koutantou in Athens, Kirsten Donovan and William James in London, writing by Mike Peacock)

"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 phone.

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 budget reforms to help Italy stave off a debt crisis that is threatening the entire euro zone.

Berlusconi, who has been under pressure to resign for weeks as markets pummeled Italy, also said his decision to resign was "a gesture of responsibility" to the country.

But he said he was opposed to any form of transitional or national unity government -- which the opposition and many on the markets favor -- and that an early election was the only alternative.

Markets showed little or no relief that a man they saw as an obstacle to economic reform planned to leave office.

The yield on Italy's 10-year benchmark bonds rose sharply to near 7.00 percent, a level widely seen as unsustainable at which Portugal, Greece and Ireland were forced to seek a bailout. Italy's FTSE MIB index fell 3.0 percent.

ALFANO PROPOSED

In a separate interview with La Stampa newspaper, Berlusconi said he saw an election being held at the start of February and that PDL party secretary and former justice minister Angelino Alfano would be the center-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.

Berlusconi's delayed resignation is highly unusual in Italy and several leftwing newspapers suggested he might be playing for time and would not eventually step down. But he gave a string of interviews on Wednesday underlining that he would resign.

Commentators said the fact that President Giorgio Napolitano had announced the resignation plan in an official statement would make if extremely difficult for Berlusconi to renege. They suggested his priority now was to keep his center-right coalition in power.

Votes on the economic reforms in both houses of parliament are likely this month. Opposition leaders may try to bring them forward in order to end as soon as possible the flamboyant billionaire media tycoon's 17-year dominance of Italian politics.

Worries about the Berlusconi government's ability to implement reforms to boost Italy's sluggish growth and cut its huge debt have helped fuel a rise in Italy's borrowing costs to unsustainable levels, weighing on the euro and stock markets.

Global equity markets and the euro rose after Berlusconi's decision on hopes that a new leader will act more aggressively to tackle the crisis in the euro zone's third largest economy, which is jeopardizing Europe's single currency project.

CONSULTATIONS

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.

Pier Luigi Bersani, leader of the opposition center-left Democratic Party, repeated a proposal to form a transitional government spanning the political spectrum.

Berlusconi and his closest allies a government of technocrats -- an option favored by markets and, it is thought, Napolitano -- would be an undemocratic "coup" against the 2008 election result.

EU inspectors were due to arrive 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.

Even when Berlusconi goes, there is no guarantee that reforms will be quickly implemented, and relief on markets may not last long.

The cost of using Italian bonds to raise funds rose after the clearing house LCH.Clearnet SA increased the margin Italian debt. [nL6E7M9192]

When LCH.Clearnet took similar action on Portuguese and Irish debt as bond yields soared, it added to selling pressure on the paper. Both countries were later forced to seek bailouts.

(Additional reporting by Giselda Vagnoni and Stefano Bernabei; editing by Barry Moody and Kevin Liffey)

An easing in Chinese inflation also soothed fears about the world's second-largest economy, bolstering oil and copper prices and underpinning Hong Kong shares.

However, doubts that the European Union will be able to stop the sovereign debt crisis from spreading continued to fuel interest in safe-haven gold, pushing prices higher.

European shares were expected to rise, with financial spreadbetters expecting Britain's FTSE 100 .FTSE index to open up 1.2 percent, Germany's DAX .GDAXI to rise 1.7 percent and France's CAC-40 .FCHI to gain about 1.1 percent.

MSCI's broadest index of Asia Pacific shares outside Japan rose as much as 1.7 percent before trimming gains to around 1 percent, while Japan's Nikkei stock average .N225 closed up 1.2 percent.

Berlusconi said on Tuesday he would leave office after parliament approves a budget law that includes reforms demanded by Europe, but Italy looks set for prolonged political uncertainty after his announcement.

"The news helped stabilize the euro and prompted investors to buy back shares, but there is still uncertainty in the euro as reshuffling its leader alone doesn't guarantee Italy's fiscal situation will improve," said Yuuki Sakurai, CEO of Fukoku Asset Management.

"Until the problem of sovereign debt, the last resort for investors, is resolved, investor preference for liquid assets such as cash and Japanese government bonds remains in place."

The euro held firm, pushing to $1.3835 against the dollar. The single currency rose as high as $1.3847 in New York on Tuesday.

China's annual inflation rate eased to 5.5 percent in October from 6.1 percent in September for a third straight month of decline from July's three-year peak and Premier Wen Jiabao said prices had fallen further since then.

Chinese producer prices rose 5 percent in the year through October, down from a 6.5 percent rise in the year to September.

Easing price pressures helped fuel expectations that China may start to ease monetary policy as exporters feel the impact from slowing global growth. But Beijing is not seen loosening its grip on the property market for now, despite recent signs of slowing sales.

Hong Kong's Hang Seng Index .HSI rose by around 2 percent while the Shanghai Composite Index .SSEC gained 0.3 percent.

Brent crude gained for a fifth day, rising 0.5 percent to $115.57 a barrel, and copper rose 1.5 percent, as factory output data affirmed China's economy is slowly moderating but not battling a sharp slowdown right now.

ITALY YIELDS SURGE

Berlusconi's resignation could come this month, with votes likely in coming weeks on Italian budget measures including austerity reforms to cut debt and bring borrowing costs under control.

The yield on Italy's benchmark 10-year bond hit a 14-year high of 6.79 percent on Tuesday, approaching levels seen in the government bonds of Portugal and Ireland when they had to seek bailouts.

Italy is the third largest economy in the euro zone and failure to fix its debt problems would have a far bigger impact on the region than difficulties in Greece.

Investor jitters over Italy's debt has kept the spread on Italian government bonds over Bunds to 490 basis points.

Despite the rise in riskier assets such as stocks and oil, and a firmer euro and the dollar, gold gained as much as 0.5 percent to $1,794.09 an ounce. It briefly rose above $1,800 on Tuesday, its highest in seven weeks, before falling on news from Italy.

"While market focus has shifted to Italy from Greece, the situation in the euro zone is far from instilling optimism," said Yuichi Ikemizu, branch manager for Standard Bank in Tokyo.

"Gold is underpinned by favorable factors, such as global growth slowdown and the euro zone debt problems."

Ikemizu said physical investors are sidelined given the high price level, but funds buying helped pushed prices higher.

The market was temporarily relieved by Italy's political shakeup, although Greece remained undecided on its next leader. Party leaders were locked in talks on a unity coalition, with the EU seeking an immediate deal to save the country's finances.

EU finance ministers failed to make progress on Tuesday on ways to shore up sagging banks and avert a credit squeeze, as rising borrowing costs for Italy make it more difficult for European banks to borrow as they are increasingly reluctant to lend to one another.

Such uncertainties over key issues kept gains in Asian credit markets modest.

The spreads on the iTraxx Asia ex-Japan investment grade index - a gauge of investor appetite for risk - narrowed by about 5 basis points early on Wednesday.

U.S. Treasuries also edge up slightly on Wednesday in Asia.

"So what if Berlusconi eventually does the right thing? We'll rally for a period - maybe a day or two - then just sell off again," said a note from Societe Generale.

"The Greeks have delivered nothing, there's growing feeling that Italy will possibly go the same way, the EFSF has been shown to be no panacea - and soon it won't even get funded."

Earlier this week, the European Financial Stability Facility, the euro zone's bailout fund, had difficulty finding buyers for 10-year bonds issued to support Ireland.

(Additional reporting by Umesh Desai in Hong Kong; Editing by Kim Coghill)