By Roberto Landucci
ROME (Reuters) - Italy's fragile coalition government, already struggling to contain deep divisions over tax and economic policy, woke up to a whole set of new problems on Friday after Silvio Berlusconi's conviction for tax fraud was upheld by the supreme court.
Just three months after center-left Prime Minister Enrico Letta took office at the head of an uneasy alliance with Berlusconi's People of Freedom party (PDL), Italy, the euro zone's third largest economy, is again mired in uncertainty.
Letta repeated on Friday that Italy must have a stable government, saying the last thing it needs is to be worn down by partisan battles.
But everything hangs on the unpredictable reaction of Berlusconi.
The 76-year-old billionaire and his supporters have reacted angrily to his conviction and prison term, the first definitive sentence he has received in dozens of trials during his two decades in politics.
While he is unlikely to spend any time in jail due to his age, the verdict was an unprecedented blow and he could lose his seat in parliament within weeks with a vote on expelling him from the Senate likely in September.
He has declared he will continue his political activities under the "Forza Italia" (Go Italy!) name of his first party and press for a reform of the justice system, with speculation growing that his daughter Marina may succeed him as party leader.
So far he has given no indication of wishing to bring the government down and pitch Italy into fresh elections, but the already dim prospects of significant reforms to revive Italy's stagnant economy and cut its massive debt have receded further.
Agreement over thorny issues such as privatizations due in the autumn or the much-disputed IMU property tax which Berlusconi wants to scrap but which would blow a hole in already strained public finances will be difficult.
"It depends on the PDL," deputy Economy Minister Stefano Fassina, from Letta's center-left Democratic Party (PD) told Reuters.
"It's not something which can be settled in the next few hours but over the next few weeks, we'll have to settle the IMU issue and on an issue like this, it can't just be about Berlusconi's personal interests," he said.
Problems just as serious could also come from Fassina's own fractious camp, with many in the center-left unhappy at the prospect of remaining in alliance with a convicted tax evader. To add to the problems facing Letta, Matteo Renzi, the ambitious young mayor of Florence, is widely expected to mount a bid to lead the party.
Letta himself said that the situation was "politically very delicate" and he called on all sides to show responsibility in the interests of the country. But he acknowledged that there were limits to what could be accepted.
"I don't consider that continuing at any cost is necessarily in the interests of the country," he said.
For all the drama surrounding the sentence, financial markets have shrugged off the ruling at least for now, encouraged by the European Central Bank's guarantee to backstop countries that ran into difficulty on the bond markets.
The main barometer of investor sentiment, the spread between Italian 10 year bond yields and their safer German equivalents, actually fell on Friday to 262 basis points from 270 the previous day.
Italy's blue-chip share index opened flat, although shares in Berlusconi's Mediaset media empire fell as much as 4 percent in volatile early trade.
But the calm could change if prolonged political instability fuelled doubts about Italy's badly strained public finances and created the kind of pressure that brought down Berlusconi's last government as the euro zone crisis peaked two years ago.
With Italy's stagnant economy showing the first faint signs of improvement after two years of recession, it can ill afford months of debilitating stalemate.
Claudio Aspesi, an analyst at research firm Bernstein said markets anticipated little action during the August summer holidays but tensions would intensify once activity picked up after the break.
"In September this could reignite concerns on the government's survival and the repercussions for the economy," he said.
President Giorgio Napolitano, the man who would have to decide whether to call new elections if the ruling coalition fell apart, has urged calm, saying the country needed "serenity and cohesion."
Whether that will be possible will be seen in the months ahead.
As well as the tax fraud case, Berlusconi is also fighting a separate conviction for paying for sex with a minor, in the notorious "bunga bunga" prostitution case that tarnished his final months in office in 2011.
(Additional reporting Danilo Masoni, Francesca Landini and Francesco Canepa; Writing by James Mackenzie and Silvia Aloisi; Editing by Barry Moody)