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A woman casts her vote in a polling station in Rome February 24, 2013.STRINGER/Reuters

Italy's tight election suddenly has investors worried as exit polls point to a political deadlock that could make the country effectively ungovernable.

Italian markets sank late in the day, after exit polls released in the mid-afternoon, local time, revealed that Silvio Berlusconi's centre-right coalition was coming on strong in the senate, the upper chamber of the Italian parliament. Although the centre-left coalition, led by Pier Luigi Bersani, was on course to win in the lower house of parliament, known as the chamber of deputies, it needs a majority in both houses to form a stable government.

The Milan stock market rose more than 3 per cent Monday morning, as investors took the view –wrongly, it appears – that the centre-left would take both houses and embark on an austerity-lite and economic reform program that would both buy favour with Italian voters, international investors and European leaders.

But by the end of the day, the Milan bourse has lost virtually all its gains, finishing up only 0.7 per cent. Sovereign Italian bond yields, which had fallen earlier in the day, rose 4 basis points (100 basis points equals 1 percentage point). Monday's rise means that Italian borrowing costs have climbed a hefty 36 basis points the last month, though they are still down significantly since last September, when the European Central Bank came to the rescue of distressed borrowers.

The euro fell marginally. London's FTSE-100 index was up slightly.

Economists and analysts said that the election in Italy, the euro zone's third biggest and most indebted economy, and the one with the second deepest recession, was driving the markets late in the trading sessions.

In a note called "Equity market gains tempered by bunga bunga fears," Michael Hewson of London's CMC Markets, said "After initially showing significant gains across all of Europe, the news that the comeback king Berlusconi could be proving to be more Teflon coated than normal sent markets sharply into reverse gear, with reports that he was way ahead in Senate polling in Lombardy."

Mr. Belusconi, 76, the leader of the centre-right People of Freedom party (PdL), was written off for dead a year ago, after he was effectively ousted as prime minister at the height of the debt crisis. He was replaced by technocrat prime minister Mario Monte, whose centrist alliance had an exceedingly poor showing in the exit polls.

But Mr. Berlusconi tapped into investor anger over the tax hikes and other austerity measures launched by Mr. Monti in his "Save Italy" program. In his campaign, he took an anti-austerity, anti-German stance, vowing to reduce taxes. In an gambit dismissed as desperate and perhaps illegal by rival politicians, he said he would reimburse the new property tax, called IMU, imposed by Mr. Monti.

By early evening, local time, it appeared that an epic battle was under way between the centre-right and centre-left for control of the senate. Mr. Bersani's party officials, who seemed optimistic earlier in the day about winning the election, declined to make any predictions in the evening. Official results may not be known until early Tuesday.

If the election proves inconclusive, leading to a period of political instability that could trigger another election, markets are bound to sink on Tuesday.