The lira and bond prices fell sharply in early morning trading, but bounced back to finish higher at the end of the day. Italian bonds finished 33 basis points higher at 104.47, while the lira closed at 984 against the mark .
However, analysts warned that investors had misread the situation and predicted further turbulence to come. Many City economists believe the markets have not yet fully faced up to the reality of what is happening in Italy.
Philip Chitty, of ABN-Ambro, said: "The markets have missed the point. The possible delay raises doubts that Italy will be able to secure EMU membership at all."
Even if investors are not counting on Italy joining EMU in 1999, they are still betting on an early Italian entry. Italian government bond yields have fallen sharply over the past two years, reflecting the belief that Italian and German interest rates are going to converge.
In part this is because inflation is low, and Italian Prime Minister Romano Prodi has promised substantial cuts in the government deficit. But investors are also relying on EMU membership to keep Italian inflation under control in the long term.
The prospect that the EU will keep Italy out of the single currency in 1999 has helped bolster confidence in EMU. Michael Lewis of Deutsche Morgan Grenfell said: "It reduces the risk that EMU will be unsustainable. If these rumours are correct, there is still a flightpath to EMU, with Italy still close to the landing strip."
However, investors may be over-estimating the chances of Italy landing in 2002. Julian Jessop of Nikko said: "The optimists believe that Italian fiscal and monetary discipline can continue, and that Italy is now even more likely to enter EMU in 2002. The pessimists believe that it will be even more difficult for Italy to join by 2002. I believe the pessimists will win out and the Italian market will get a kicking."
The critical question is whether Italy can meet the Maastricht criteria in 2002. Italy's budget deficit last year was 7.5 per cent of GDP. Squeezing that down to the Maastricht 3 per cent will not be easy. Some of the Italian government's measures to bring the deficit down are one-off policies, including the Euro-tax which is supposed to be repaid from 1999. It remains unclear whether the Italian Prime Minister has enough political support to squeeze the government belt tighter in future.
If the markets suspect Italy cannot make the Maastricht criteria, Mr Chitty argues: "We could get into a vicious circle." The Italian government debt exceeds 120 per cent of GDP, so interest payments cost a considerable amount each year. If investors sell government bonds, pushing up the cost of interest payments then the deficit is likely to rise even further.
Mr Lewis believes confidence in the Italian markets will continue: "The risk of it unravelling in the next year is quite low."